A Dozen Ways You Can Use Seth Klarman’s “Margin of Safety” Approach When Voting

When you cast a vote you are making an investment. You should vote using a sound process, just as you should use a sound process when investing. Having a sound decision making process means reading a lot and talking to people you trust who have good judgment before making a decision. When it comes to a decision about a particular candidate in an election I would frankly rather read a transcript of a speech than listen to it. But if you like listening to speeches, do that. In general, I prefer an interview to a scripted speech anyway since you get a better sense of whether the candidate has any sense when they are not scripted. Yes, I would rather read a transcript of the interview. Reading any policy papers that are available is also helpful but few people will actually do that. Of course, more than just getting the facts is required. As Charlie Munger has said: “I don’t know anyone who’s wise who doesn’t read a lot. But that’s not enough: You have to have a temperament to grab ideas and do sensible things. Most people don’t grab the right ideas or don’t know what to do with them.” As an aside, if you don’t like reading about Munger’s ideas, this may not be a good blog for you to read.

In writing blog posts about what people like Bill Murray, Rza and Louis CK can teach about investing, I am trying to make a point about sound decision-making principles being universally applicable. Investing is about making good decisions. For example, someone like Charlie Munger does not use a different decision making methodology when voting than he does when he is investing or making a charitable donation. A key point about making decisions of any kind is stated simply by Munger: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” This applies both to the way you vote and how you analyze a candidate. The best way to be smart, is to not be stupid.

I have previously written a blog post on Seth Klarman that included some quotes from his excellent book Margin of Safety. Few people reading this post will be willing to pay the $1,000 that a used copy of that book sells for on Amazon. I suggest that you instead borrow a copy of Margin of Safety from a friend or somehow find another way to read it. As an aside, I’m hoping that Klarman allows someone to republish this book soon since the world needs books like this now more than ever. Any sane publisher would do so in a heartbeat. “Hey Seth. The investing world needs you! Please republish the book!”

The quotes from Margin of Safety in the text below are in bold as is usual, but in this post I have substituted the words “voter” for “investor” and “candidate” for “investment” to make my points.

1. “Rather than targeting a desired rate of return, even an eminently reasonable one, [voters] should target risk.”  Klarman is using the term “risk” in the broadest sense. He knows that very few things in life involve just “risk” if you use Richard Zeckhauser’s definitions. Almost everything in life involves decisions that have outcomes which will be determined by “uncertainty and ignorance” rather than “risk” since it is rare that the probability distribution of future outcomes is known. In other words, life is almost never like roulette, where you know the odds and the probability distribution. The way Howard Marks puts it is that there is no definitive future at any given point in time and instead what we all face when looking forward in time can only be represented by probability distributions.

zeck

Given the inevitable risk, uncertainty and ignorance that you face in life, one thing you want to avoid is a candidate who will often create “concave” situations (small upside and big downside). Stated differently, what you want to avoid is a candidate who is what Taleb calls a fragilista. Taleb’s fragilistas develop and promote concave propositions that promise low or modest upside gains, but ignore the possibility of catastrophic risks. Does the candidate understand this concept? Do they have a sound decision-making process? Or are they oblivious to actions which exhibit negative outcome asymmetry?  Nassim Taleb elaborates:  When you inject uncertainty and errors into airplane ride (the fragile or concave case) the result is worsened, as errors invariably lead to plane delays and increased costs —not counting a potential plane crash.” Taleb continues by saying that The fragilista “defaults to thinking that what he doesn’t see is not there, or what he does not understand does not exist. At the core, he tends to mistake the unknown for the nonexistent.”

2. “Smart [voters] stick to [candidates who stay] within their circle of competence, within which … they have the capability to understand.” This is the only quote of Klarman’s in bold in this post that wasn’t in Margin of Safety, but it is something Klarman believes in as evidenced by this bolded quote from another source. The book Margin of Safety has a great index but I can’t find the “circle of competence” in the index or text. This is a bit odd, but it is what it is. I would say that in general that Margin of Safety is not a book that digs into investor psychology like Thinking Fast, and Slow or Influence. In any event, the circle of competence idea when applied to an election decision is simple:  Does the candidate know what they do not know? Do they understand what a circle of competence is? Do they stay within that circle?  Do they seek experts when they are outside their circle of competence? Do they avoid getting advice from poseur faux experts who don’t know what they don’t know and stray from their circle of completence?

3. “One of the recurrent themes of this book is that the future is unpredictable.”  “[A nation] must be prepared for any eventuality.” If a country has done its preparation correctly it has this thing called a constitution that prevents an idiot who somehow gets elected to office from ruining a nation and its way of life. Every nation needs a constitution that is structured so well that an idiot could be elected to the highest office in the land and the nations will get through that difficult time, “because sooner or later, one will” to paraphrase Warren Buffett. There is a separation of powers and checks and balances in the US Constitution for very good reasons. The people who wrote the US Constitution were aware that someone might someday end up being president who was unwise or had a lousy temperament. So they wrote it carefully to limit the power of  a single person by making sure political power was distributed. Not only is there a constitution that provides protection in the case of the United States but there is also the extraordinary people of the nation itself as a buffer against idiocy.

4. “An irresolvable contradiction exists: to [vote intelligently], you must predict the future, yet the future is not reliably predictable.” If the candidate for elected office believes they have an IQ that is greater than t actually is that is a red flag on their suitability to perform the duties of an elected official. Munger again:

“A [elected official] with an IQ of 160 and thinks it’s 180 will kill you,” he said. “Going with a [candidate for office] with an IQ of 130 who thinks its 125 could serve you well.” “Smart people aren’t exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods.” “You need to have a passionate interest in why things are happening. That cast of mind, kept over long periods, gradually improves your ability to focus on reality. If you don’t have the cast of mind, you’re destined for failure even if you have a high IQ.”

5. “A margin of safety is [is intended to] allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” As Charlie Munger has said: “Proper [voting] is like engineering. You need a margin of safety. Thank God we don’t design bridges and airplanes the way we [vote for political candidates].” When choosing who to vote for it is wise to ask yourself questions like: Do the candidate’s previous actions reflect margin of safety principles?  Do they leave a margin for error, bad luck or extreme volatility?  Are they thoughtful in making decisions using a sound process or are they quick to make judgments before they think through an issue? Do they make decisions like an engineer designs a bridge? Does the candidate have a temperament that will allow them to make the right decisions in a crisis? Will they conduct themselves in a way that does not precipitate crisis after crisis?

6. “The river may overflow its banks only once or twice in a century, but you still buy flood insurance.” Black swans are highly unlikely but very impactful events that have causes which are explainable, but only after the fact. We know Black Swans happen. Does the political candidate in the election understand that you must invest to capture the benefits of positive Black Swans and also invest to prepare for unpredictable negative Black Swans? Do they know that you can’t predict when negative Black Swans will arrive but that you can prepare?

7. “Think for yourself.” If you consider yourself a member of a political party and it nominates candidate X, why would you vote for that candidate if you have actually done your own research and drawn you own conclusions?  Why would you not do your own research and draw your own conclusions? Think! The power of thinking for yourself has been a consistent message on this blog.

8.“[Smart voters] pay attention to financial reality in making their decisions.” Does the candidate make promises that are grounded in financial reality? Do they make proposals that are achievable? In making a decision a voter should use an opportunity cost approach as described by Munger: “If you take the best text in economics by Mankinaw, he says intelligent people make decisions based on opportunity costs — in other words, it’s your alternatives that matter. That’s how we make all of our decisions. The rest of the world has gone off on some kick — there’s even a cost of equity capital. A perfectly amazing mental malfunction.  In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That’s your opportunity cost. That’s what you learn in freshman economics.”

9.“Successful [voters] tend to be unemotional, have confidence in their own analysis and  judgment.” Here’s Charlie Munger again on the importance of avoiding mistakes that can be made due to emotional or psychological factors. Increasing rationality and improving as much as you can no matter your age or experience is a moral duty. Too many people graduate from [college] today and think they know how to do everything. It’s a considerable mistake.” Be rational. Decide carefully, but do decide.

10. “A [candidate for office] should be inspected and re-inspected for possible flaws.” Who should I quote now? Yep, Munger: “The best single way to teach ethics is by example: take in people who demonstrate in all their daily conduct a good ethical framework. But if your ethics slip and people are rewarded it cascades downward. Ethics are terribly important, but best taught indirectly by example. If you just learn a few rules [by having ethics taught in school] so they can pass the test, it doesn’t do much. But if you see people you respect behaving in a certain way, especially under stress, [that has a real impact].” “I think we have lost our way when people …fail to realize they have a duty to the rest of us to act as exemplars. You do not want your do not want your [public officials] to be setting the wrong moral example.”

11. “What appears  to be new and improved today may prove to be flawed or even fallacious tomorrow.” Sometimes an electorate is hoping for “a change” from the status quo. This is understandable. But it is wise to make sure that the change is for the better. Sometimes people jump out of what they think is a frying pan and into a fire. Munger again: “Opportunity cost is a huge filter in life. If you’ve got two suitors who are really eager to have you and one is way the hell better than the other, you do not have to spend much time with the other. And that’s the way we filter opportunities.”

12. “[Voting] is serious business, not entertainment.” When you vote you are making decisions that can have a major impact on something that is precious. Your voting decision should not be decided on the basis of a talk show performance or other events with entertainment value. Do the research. Think.  Select wisely.  And do actually make a selection. Not voting is voting. Protest votes have no place in elections, especially in 2016. Make your vote count.

I will have attempted to be relatively apolitical in this post. I have also tried to make the explanation of a sound decision making process applicable to any election, not just the US Presidential election that will take place soon. Reuters reports that Klarman himself: “is registered as an independent voter and has given money to candidates from both parties in the past.” In the United States presidential election Klarman has said: “I will continue to find ways to support Hillary Clinton and defeat Donald Trump. He is completely unqualified for the highest office in the land.” The views of Klarman are similar to Munger’s statement on the  election: “The last person, almost, I’d want to be president of the United States is Donald Trump.”

My intent in writing these blog posts is to teach people how to make better decisions and making this post partisan interferes too much with that mission in this case. I would rather teach someone to fish than hand them one.  I’ve set out my decision making process many times. It should not be hard to figure out who I will vote for in a given case. What I hope that you do is think for yourself after doing the research, just as you should do in investing. Be rational rather than emotional. Decide based on facts. Be smart by not being stupid, stay in your circle of competence and find candidates who think the same way.

One of my favorite recent stories took place at the recent Rio Olympics: “The U.S. boat was in third place halfway through the race when coxswain Katelin Snyder shouted the magic words: ‘This is the U.S. women’s eight!’ In the bow seat, Emily Regan could feel her end of the boat rise, as if the whole shell were taking flight. ‘It was like I wasn’t even touching the water,’ she said.” For an American citizen it is helpful right now to remind yourself that: “This is the United States of America!” We will get through this year, the next four years, or anything else that is thrown at us. Despite the existence of that buffer, every American who is eligible needs to vote. Get the hell out and vote. Your country needs you.

Notes:

25iq on Seth Klarman https://25iq.com/2013/07/15/a-dozen-things-ive-learned-from-seth-klarman/

Margin of Safety: https://www.25iqbooks.com/books/109-margin-of-safety-risk-averse-value-investing-strategies-for-the-thoughtful-investor

Klarman on the US presidential election: http://www.politico.com/story/2016/08/seth-klarman-supports-clinton-226663

Munger on the US presidential election: https://www.youtube.com/watch?v=1Bb3cvrxdVs

Antifragile:  https://www.25iqbooks.com/books/12-antifragile-things-that-gain-from-disorder-incerto

Poor Charlie’s Almanack: https://www.25iqbooks.com/books/215-poor-charlie-s-almanack-the-wit-and-wisdom-of-charles-t-munger-expanded-third-edition

Charlie Munger: https://www.25iqbooks.com/books/54-charlie-munger-the-complete-investor-columbia-business-school-publishing

Michael Mauboussin: http://www.michaelmauboussin.com/excerpts/MTYKexcerpt.pdf

A Dozen Ways to Apply the Lessons Taught in the Book “The Most Important Thing” by Howard Marks

When I am asked by someone what book they should read first to learn about investing  I often suggest Howard Marks’ The Most Important Thing https://www.25iqbooks.com/books/207-the-most-important-thing-illuminated-uncommon-sense-for-the-thoughtful-investor-columbia-business-school-publishing

The book does not take too long to read and the points Marks makes are simple and understandable.  The Most Important Thing is currently a top five rated book on my book discovery web site https://www.25iqbooks.com/. Warren Buffett has said about this book: “This is that rarity, a useful book. When I see memos from Howard Marks they’re the first things I read. I always learn something and that goes double for this book.” The only reason I might hesitate in making The Most Important Thing my first recommendation is that some people may need to read a survey book on investing first to learn some terminology and basic concepts. For that primal level and survey type introduction to investing I usually chose one of the books by the Bogleheads or John Bogle himself.

This post is not a book review. What I will do in this post is explain how to identify situations where you can apply the ideas in the book.. The key skill you need to acquire to do this well is pattern recognition. The more you work at applying these ideas, the better you will get at applying these principles, the more fun you will have with the process, the more you investing skill you will acquire [repeat]. What I just described is an example of a positive feedback loop. As Mae West once said: “Too much of a good thing can be wonderful.” Improving your investing results is a very good thing indeed.

Howard Marks is a value investor. Someone might say: “What does value investing have to do with other investing systems?” The answer to that question is: “All intelligent investing is value investing.” Who said that? Charlie Munger. Why did he say that?  Because the foundational principles of value investing are universal. The need for a margin of safety, a business valuation process and phenomena like moats are universally applicable to any style of investing. These principles do not apply to speculation, but that is a subject for another post.

To convey my points in this post I decided to take an investing style that many would consider to be very different from value investing and show that they are in fact based on the same principles applied in different ways to different types of assets. That other investing system I will discuss here is venture capital. Venture capitalist and entrepreneur Andy Rachleff has said: “My investment idol is a guy named Howard Marks, who runs a hedge fund in LA., you might know called Oaktree. He’s as well known for his writings as he is his returns, which are very, very good. He once wrote an article about investing which I think relates well to entrepreneurship as well.”

As always on this blog, the words written or spoken by the subject of the post (in this case what Howard Marks wrote in his book The Most Important Thing) are in bold.

1. “The expected result is calculated by weighing each outcome by its probability of occurring.” Once upon a time in 1999, Sergei and Larry were looking to raise some capital for a business they were calling Google. One of the venture capital firms the Google founders pitched in seeking an investment was Kleiner Perkins, which saw hundreds of other pitches that year, just like they do every year. Out of all of the firms Kleiner considered that year they made 85 investments. One of those 85 was an investment of $12.5 million in Google (another venture capital firm named Sequoia made the same bet). This Kleiner IX fund also invested in AutoTrader and Martha Stewart Living Omnimedia Inc. in 1999 but it is not much of an exaggeration to say that the Google investment was all that mattered in that venture capital fund and in Silicon Valley in general that year.

In making a decisions like Kleiner did in 1999, the venture capital firm performs an “expected value” analysis which is: the weighted-average value for a distribution of possible outcomes. In other words, expected value is calculated by multiplying the payoff (i.e., stock price) for a given outcome by the probability that the outcome materializes. As Buffett likes to say: “take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.” Venture capital firms have a hard problem in that it is not easy to make the expected value calculation since there is a great deal of risk, uncertainty and ignorance related to the decision. You will sometimes hear venture capitalists say that they make decisions based on their gut instinct, but this really is an investor making an expected value calculation using rough inputs determined in many cases in their head based on pattern recognition skills. Precise inputs are not required to make an expected value calculation and the math can be done in your head if you know it well and you are seeing a substantial bargain that more than covers any mistakes on your part. Michael Mauboussin lays out a key part of the task for any investor in his usual clarifying manner in his essay “Ruminations on Risk”:

“Subjective probabilities describe an investor’s “degree of belief” about an outcome. These probabilities are rarely static, and generally change as evidence comes along. Bayes’s Theorem is a means to continually update conditional probabilities based on new information. Bayesian analysis is a valuable means to weigh multiple possible outcomes when only one outcome will occur.  As Robert Hagstrom notes, the textbooks on Bayesian analysis suggest that if you believe that your assumptions are reasonable, it is perfectly acceptable to make your subjective probability of a particular event equal to a frequency probability. Thinking about the investing world probabilistically is critical to the margin of safety concept.”

2. “Many futures are possible, to paraphrase Dimson, but only one future occurs.  The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck.  The performance of your portfolio under the one scenario that unfolds says nothing about how it would have fared under the many ‘alternative histories’ that were possible.” They key point is this is that Kleiner and Sequoia did not know that Google would be a tape measure financial home run. It was enough that they thought it had a significant chance to do so and that the potential payoff was massive. So how does a venture capitalist deal with this uncertainty about the future? Warren Buffett describes the approach:

“If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments.  Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.  Most venture capitalists employ this strategy.  Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.”

This approach employed by venture capitalists outlined by Buffett is essential given the nature of convex bets. As I have written in previous blog posts, the value that is uncovered by venture capital is achieved through a process that is based on trial and error by the entrepreneurs. There is no absolute certainty in investing. Ever. There is no future. What exists now and in the past is what we have and when we look forward all we should think about is a probability distribution. What this means is that when it comes to the future, there is no “there there” yet. For this reason investing of all kinds is inherently a probabilistic activity. In any form of investing you can be wrong even though you made the right decisions based on probability. And vice versa. Venture capital investing is unique in that the bargains being discovered are convex and outcomes that result in financial success being determined by very few winners. Startups are not the sort of undervalued asset that a traditional value investor seeks. But both types of assets should be considered using the same basic principles.

3. “Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have.  You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess.  You have to react differently and behave differently.  In short, being right may be a necessary condition for investment success, but it won’t be sufficient.  You must be more right than others… which by definition means your thinking has to be different.” “To achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate.  That’s not easy.” It is provable mathematically that you cannot beat the market if you are the market. To outperform the market you must take positions that are at odds with consensus and be right about that decision. As an example, in the spring on 1995 Tom Alberg was asked to be an investor in a startup created by Jeff Bezos by the name of Amazon. Alberg wasn’t sure whether to make that investment:

“Bezos hadn’t launched the site yet. He had a good business plan that was solely focused on books. It was going to break even in year two. Sounded attractive. The other thing, I loved bookstores…. I met with him, and I thought he was a very smart guy and intrigued. I said: Well, I am potentially interested but let me think about it. The next week I went to Barnes & Noble bookstore. I was trying to buy a book for my son, who was starting a business. And I had that sort of bookstore frustration where the salespeople didn’t know. I finally figured out the book I wanted and they didn’t have it. So, I said maybe there is room for online. Then, every month for the next couple months, they launched it in June, I think, Jeff would send me an email and say: ‘Gee, we’ve now sold books in eleven states.’ And then I get an email and it said: ‘Revenues are up to $70,000 a week.’ And: ‘We just sold our first book to a European customer.’ I met with him a couple more times, and invested.”

Lots of people turned Jeff Bezos down that year. I know one such person and it impacts his investing to this day since it causes him in my view to write too many checks. For better or worse I was not asked to invest. But I know seven people who said yes.How did it workout for the people who invested?

Jeff Bezos: “The riskiest moment for Amazon, was at the very, very beginning. I needed to raise $1 million at a certain point, and I ended up giving away 20 percent of the company for a million dollars.”

Charlie Rose: “A helluva a deal for somebody.”

Jeff Bezos: “A lot of people did very well on that deal (laughs). But they also took a risk, so they deserve to do very well on that deal. But I had to take 60 meetings to raise $1 million, and I raised it from 22 people at approximately $50,000 a person. And it was nip and tuck whether I was going to be able to raise that money. So, the whole thing could have ended before the whole thing started. That was 1995, and the first question every investor asked me was: ‘What’s the Internet?’”

4. “To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality.  That means the best opportunities are usually found among things most others won’t do.  After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.” “A hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.” “The most profitable investment actions are by definition contrarian:  you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high).  These actions are lonely and… uncomfortable.”  “The thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious – on which everyone agrees – turn out not to be true.” To find something that is undervalued you need to be looking where others are not looking. It has been said that the best venture capitalists are looking for something that is half crazy. Why? Well, people are generally fearful of investments that are even part crazy and that fear on the part of others can create some bargains due to mis-pricing. Something that others do not believe is valuable, or better yet, is not yet on anyone’s radar, can be offered to a venture capital investor at a bargain price. A venture capitalist is just looking for a different type of asset available at a bargain than a typical value investor. Venture capitalists are looking for a chance to purchase an asset that is highly “convex,” which means there is a huge upside and a relatively small downside. For example, a venture capitalist is not buying something like a well-known consumer product brand at less than intrinsic value. They are instead is looking for convex bets that can be bought at less than their true value. As is the case with any other financial asset a venture capitalist can pay too much for an asset that has convexity. But there were some people in the venture capital business who though the valuation of Google in 1999 was too high and passed. The 1999 investment in Google by Kleiner and Sequoia had tremendous convexity (massive upside and relatively small downside). The most these two venture firms who invested in Google in that round could lose is what they invested. Similarly, early seed round investors in Amazon could only loose what they invested. If they still owned those Amazon shares, the total gain would greater than ~38,000%.

amzn-ret

5. “I’ve said for years that risky assets can make for good investments if they’re cheap enough.  The essential element is knowing when that’s the case.  That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.” To discuss risk you must first start with a definition. My favorite definition is from the work of Richard Zeckhauser who teaches at Harvard:

 zeck

Zeckhauser explains an important take away from those chart:

“The returns to UUU investments can be extreme.  We are all familiar with the Bell Curve (or Normal Distribution), which nicely describes the number of flips of a fair coin that will come up heads in a large number of trials.  But such a mechanical and controlled problem is extremely rare.  The standard model often does not apply to observations in the tails. So too with most disturbances to investments. More generally, movements in financial markets and of investments in general appear to have much thicker tails than would be predicted by Brownian motion, the instantaneous source of Bell Curve outcomes.  That may be because the fundamental underlying factors produce thicker tails, or because there are rarely occurring anomalous or weird causes that produce extreme results, or both. Nassim Taleb and Benoit Mandelbrot posit that many financial phenomena are distributed according to a power law, implying that the relative likelihood of movements of different sizes depends only on their ratio. Power distributions have fat tails.  In their empirical studies, economists frequently assume that deviations from predicted values have normal distributions. That makes computations tractable, but evidence suggests that tails are often much thicker than with the normal.”

The key point is that venture capital is all about exceptions and phenomenon that express themselves in power laws. It is not an investing discipline that is ruled by a Bell curve, but it is still a probabilistic activity. I have written a blog post on what I believe is another style of venture capital investing by Dave McClure which I believe harvests a different type of alpha which is important if the style is to spread to more cities and grow in size.

6. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, “The prospective return isn’t high enough to warrant bearing all that volatility.” What they fear is the possibility of permanent loss.” “Riskier investments are ones where the investor is less secure regarding the eventual outcome and faces the possibility of faring worse than those who stick to safer investments, and even of losing money. These investments are undertaken because the expected return is higher. But things may happen other than that which is hoped for. Some of the possibilities are superior to the expected return, but others are decidedly unattractive.” Risk comes from not knowing what you are doing. The best way to lower risk is to know what you are doing. It’s that simple. If riskier investments could be counted on to generate higher returns than they would not be riskier is the applicable famous Howard Marks quip on this point.

7. “First-level thinking says, ‘It is a good company; let’s buy the stock.’ Second-level thinking says, ‘It’s a good company, but everyone thinks it’s a great company, and it’s not.  So the stock’s overrated and overpriced; let’s sell.’ First-level thinking says, ‘The outlook calls for low growth and rising inflation. Let’s dump our stocks.’ Second-level thinking says, ‘The outlook stinks, but everyone else is selling in panic.  Buy!’ First-level thinking says, ‘I think the company’s earnings will fall; sell.’ Second-level thinking says, ‘I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.’” Second level thinking is about finding value that others don’t appreciate. You can’t beat the crowd if you are the crowd. Here’s Howard Marks writing in one of his wonderful essays:

“Remember your goal in investing isn’t to earn average returns; you want to do better than average. Thus your thinking has to be better than that of others – both more powerful and at a higher level. Since others may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss, or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different.”

The matrix that describes the outcomes is:

consen

8. “Cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control.  Thus we must recognize, accept, cope and respond.  Isn’t that the essence of investing?” “Processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical.  The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical. Objective factors do play a large part in cycles, of course – factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions.  But it’s the application of psychology to these things that causes investors to overreact or underreact, and thus determines the amplitude of the cyclical fluctuations.” “Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.” “In January 2000, Yahoo sold at $237.  In April 2001 it was $11.  Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions.  But that doesn’t mean many investors were able to detect and act on the market’s error.” “A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy.  The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, gets most investors into trouble.” “It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price.  And there are few assets so bad that they can’t be a good investment when bought cheaply enough.” Howard Marks believes that almost everything is cyclical. And venture capital is no exception to this rule. Other people agree the venture industry is cyclical. Bill Gurley once put it this way: “Venture Capital has long been a trailing indicator to the NASDAQ.  Venture capital is a cyclical business.” “Moreover, deep down most LPs know that performance in the VC sector is counter cyclical to the amount of money raised by VCs.” Andy Rachleff has similarly said: “[Venture capital is] a very cyclical business. So there was a cycle from 1980-1983 that looked a lot like 1996-1999. Only an order of magnitude smaller on every dimension.”  “I don’t think a bubble is an environment where things are valued highly, I think it’s an environment where crappy companies are valued highly.” Sometimes growth is valued more than profitability by markets and sometimes it isn’t. Sometimes cash is relatively easy to raise if you have a good business and sometimes you can’t raise five cents even if you have a good or even great business. Howard Marks likes to say you can’t predict but you can prepare. Having enough cash on hand to survive an inability to raise new cash for a significant period of time helps prepare a company for adverse turns in a cycle which can’t be fully predicted.

9. “Overestimating what you’re capable of knowing or doing can be extremely dangerous – in brain surgery, transocean racing or investing.  Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.” “The actions of the ‘I know’ school are based on a view of a single future that is knowable and conquerable.  My ‘I don’t know’ school thinks of future events in terms of a probability distribution.  That’s a big difference.  In the latter case, we may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.”  This is the “circle of competence” idea in all of its glory.  Risk comes from not knowing what you are doing. The best way to avoid risk is to stick to situations where you know what you are doing and to work hard to expand the areas where you do know what you are doing by learning. One thing I have seen again and again in great investors is that they spend most of their time trying to determine what they don’t know. They would much rather read a book or attend a lecture on what we don’t know than listen to crackpot theories that try to predict what can’t be predicted. This “tell me what I don’t or can’t know” approach is very different from academia since there are few people who get academic tenure for proving what we don’t know or that we can’t know something. The key point is illustrated by Charlie Munger’s desire to know where he is going to die so he can just not go there. Munger’s quip is humorous because it is so true for an investor. If you just know where you are going to lose money, you can just not go there. If only that was always true.

10. “The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies.  Thus, I suggest people try to ‘know the knowable.’”  This is the Howard Marks version of the Charlie Munger principle that “the best way to be smart is to not be stupid.” The best venture capitalists are aware of the cycle because of its impact on valuation of individual businesses but stay focused on microeconomics. They value the convexity of each business in the portfolio and give only occasional thought to Federal Reserve interest rate policy when making investments. Like Marks, a smart venture capitalist understands that they know a lot about today but nothing certain about tomorrow and the days after that. The future is not only risky and uncertain but contains the potential to reveal ignorance. By adopting a margin of safety approach one can be wrong, make a mistake and still have an acceptable result.

11. “No rule always works.  The environment isn’t controllable, and circumstances rarely repeat exactly.” Venture capital is interesting in many ways, but perhaps most interesting is that it involves people who break rules. At least one key rule is broken by each entrepreneur who hits a financial home run. If you don’t do make a decision to be different in some way and are right about that decision you are unlikely to generate convex financial returns. Operational excellence is a great thing, but to generate a 10-100X financial return you can’t be doing what everyone else is doing, only better. Every time an entrepreneur breaks a rule the risk of failure rises so they don’t want to break too many rules at once. As was the case in the story in Goldilocks and the Three Bears, the founders of a startup want the “rule breaking” to be at a “just right” level. 

12. “Where does an investment philosophy come from?  The one thing I’m sure of is that no one arrives on the doorstep of an investment career with his or her philosophy fully formed.  A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources.  One cannot develop an effective philosophy without having been exposed to life’s lessons.” There is no way to get through life and learn without making mistakes. You can certainly learn a lot and avoid a lot of pain by watching and reading about the mistakes of other people. Learning vicariously not only scales better but can be far less painful. That is why I love books so much and created my book discovery site https://www.25iqbooks.com/. But there is a big difference between knowledge and skill. Acquiring skill requires at least some real world practice. In the end, to acquire skill you need to sometimes make mistakes yourself to really learn the most powerful lessons. You can only learn so much just by watching others.

Notes:

Howard Marks: https://www.25iqbooks.com/books/207-the-most-important-thing-illuminated-uncommon-sense-for-the-thoughtful-investor-columbia-business-school-publishing

My previous blog post on Howard Marks:  https://25iq.com/2013/07/30/a-dozen-things-ive-learned-about-investing-from-howard-marks/

Alberg invests in Amazon:  http://www.geekwire.com/2015/qa-madronas-tom-alberg-on-the-changing-winds-of-venture-capital-tech-bubbles-and-bankrolling-a-young-jeff-bezos/

Kleiner’s IX fund: http://www.wsj.com/articles/SB108328387230498204

Zeckhauser: https://www.hks.harvard.edu/fs/rzeckhau/InvestinginUnknownandUnknowable.pdf

Mauboussin’s Ruminations on Risk: http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/marginofsafety.pdf

Buffett’s 1993 Chairman’s letter:   http://www.berkshirehathaway.com/letters/1993.html

Geekwire Charlie Rose: http://www.geekwire.com/2013/jeff-bezos-60-meetings-raise-1m-amazoncom-giving-20-early-investors/

ANNOUNCING 25IQ BOOKS!

I am excited to announced the launch of a book discovery and discussion community called: 25IQ BOOKS. This 25IQBOOKS image on the right side bar is clickable. Or try:  https://www.25iqbooks.com/

I have compiled a list of about 260 books on business, investing, economics, finance, technology and science as well as some biographies that I believe every serious investor should read.  This list of books will grow over time and new book categories will be added.

People can join the community on 25iqbooks by requesting an invitation on the site.

Even if you do not join this community officially you can browse the site to discover books. If you ever wanted to know what my personal bookshelves have on them, this site gives you an opportunity to find out. People ask me from time to time how they can learn more about the topics on the categories covered by 25iqbooks. My answer is: start reading these books one-by-one.

Some very smart and well-read friends of mine have already joined the community have already “up voted” and added books.

If you do join this community, please “up vote” your favorite books by clicking the arrow next to that book and feel free to add comments about books to the site. You can easily add books to 25IQ books by looking up the ten digit ISDN number on the book’s page on http://www.amazon.com and inserting it in a specified box. The one thing you must do is  identify the right categories for the book. Everything else about adding the book is automated. Right now only one book can be added at a time. Future improvements like adding more tan one book at a time and endless scrolling will be implemented depending on the site’s popularity. The site runs on only a few servers in the cloud right now, but I doubt they will be overwhelmed today.  But anything is possible.

No trolling or personal attacks of any kind are allowed n this community. Does this mean that abusers of this policy will be banished? Yes.

My plan is to write posts about many of these books. I will not write book reviews but instead will discuss how ideas in the book can be applied in the real world.

I love books and the creation of this community represents my small attempt to give back to something that has given so much to me.

“The best thing a human being can do is to help another human being know more.” Charlie Munger

A Dozen Things I’ve Learned About the Music Business (and Businesses Like It)

 

  1. “I wish there had been a music business 101 course I could have taken.” Kurt Cobain. There are many musicians like Cobain who are thrust into situations without financial help they can trust. Every musician should take a lesson from the comedian and actress Tina Fey: “I came to New York in 1997 to work on Saturday Night Live. I realized I have no head for business. And it would have been very easy for me to let someone take control of my money – for me to say, ‘Here, sign my checks…whatever.’ But… as much as it makes me super sleepy, I have to pay a lot of attention when my business manager talks to me about money. He talks to me about taxes, and I get really, really sleepy. But I listen.” Most people get bored quickly learning about business topics. I’ve thought a lot about how to fix this problem, but I really don’t have a great solution. Warren Buffett tries to make business entertaining in his own way and that helps. But the unfortunate fact is: few people are willing to do the necessary work to learn business concepts. I fear the situation will get worse with time and not better. Once upon a time people learned about business when they joined a big company and went through what was effectively an apprenticeship. Today companies are smaller and fewer people receive that training. I wrote about many of the basic business principles that apply to the entertainment business in my blog post on Louis CK. I supplement what I said in that post in my usual format below.
  1. “At the end of the day, there’s only a few major stars in the music business, and then there’s all these people that are aspiring to be that.” John Legend.  One of my favorite articles on the music business was written by Duncan Watts and is entitled: “Is Justin Timberlake a Product of Cumulative Advantage?” This article by Watts (the link is in the notes) makes important points that must be understood if you want to understand modern economics generally. The key insight is simple: People don’t make decisions independently. Something called “preferential attachment” happens in some situations and this phenomenon produces the “power law distributions that rule everything around the music industry.” This power law phenomenon is not new but as Nassim Taleb points out, it has received an accelerating boost from digitization and the internet. A writer of a story about Nassim Taleb put it this way: “We live in Extremistan, where black swans proliferate, winners tend to take all and the rest get nothing –there’s Domingo and a thousand opera singers working in Starbucks.” In an article entitled The Music Industry’s New Math New York Magazine  points out: “Since 2008, there have been 66 No. 1 songs, and six artists are behind almost half of them. (In 1986, there were 31 No. 1 songs by 29 different people).”

    The distribution of financial success in the music looks like this:

Long tail

As an example of a power law distribution in the music business: The share of concert revenue taken home by the top 1% of performers has more than doubled, rising from 26 percent in 1982 to 56 percent in 2003.

Top

As another example, the top 5 percent of musicians take home almost 90 percent of all concert revenues.

recorded

  1. “The TV business is uglier than most things. It is normally perceived as some sort of cruel and shallow money trench through the heart of the journalism industry, a long plastic hallway where thieves and pimps run free and good men die like dogs, for no good reason.” Hunter Thompson. You will see versions of this quotation by Hunter Thompson that substitute the word “music” for “TV.”  the reality is that Thompson wasn’t writing about the music business although he could have been since they share attributes. You may also sometimes see the following tag line attached to this quote: “There’s also a negative side.” While it is a clever addition, it is fake. Sorry. But that does not mean that the quote is not directionally correct. And it does make for a good quote (I love a good quote as you probably know). Anyway, “payola” in all its forms has always been a part of the music business. The word is combination of “pay” and “Victrola” (i.e. record player). At first, payola was mostly  about cash, which lead to a major scandal in the 50s that lead to a law prohibiting payments for airplay in certain situations where there wasn’t full disclosure. Payola is messy, cruel and shallow money trench, which is a shame since it can block the rise of talented people.
  1. “[Any money I make] goes straight into my bank account, where it turns all moldy and smelly.” “I didn’t go and buy a Lamborghini because I had a million dollars.” “I drive a family car—not a monster SUV but a family car that fits five people. I’ve got a house that is just big enough, too.” Dave Grohl.  This musician’s statement reminds me of something Warren Buffett once said: “There’s nothing material I want very much.” Wanting too much can make you  really miserable.  This point was made well in a line of dialogue of a fictional character in Charles Dickens’s 1850 novel, David Copperfield: “Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.” While there is no formula to get rich, staying rich is a bit easier if you can get control of your emotions.
  1. “I just don’t agree with perpetuating the perception that music has no value and should be free.” Taylor Swift.  Music is a public good, which can be a danger zone for profitability. What is a public good? Well, public goods are both non-rival and non-excludable. If I make a digital copy of your digital music, you still have your music (the music is non-rival). If I steal your phone you will no longer have a phone (a phone is rival). Music becomes “excludable” if you move the musician’s performance into a theater, since you can exclude people from hearing the performance who do not pay. Lots of important industries like journalism have this public good problem. It is not a new problem and applies to things like lighthouses and national defense.

 

Excludable Non-excludable
Rivalrous Private goods
food, clothing, cars, parking spaces
Common-pool resources
fish stocks, timber, coal
Non-rivalrous Club goods
cinemas, private parks, satellite television
Public goods
free-to-air television, air, national defense

The music business has responded to this public problem by shifting to complementary products that are excludable like concerts and merchandise sales. This works for musicians but is not enough to save the newspaper business since people will attend only so many conferences.

tour

concert

This public goods problem combined with other points that I have described above above place real and uncomfortable pressure on some people who trying to earn a living from music and similar professions. Neil Howe writes:


http://i.forbesimg.com/forbes/scripts/fb471d66.ie_scripts.js

http://i.forbesimg.com/forbes/scripts/21ef3912.ie_vendor.js

“Data from the Bureau of Labor Statistics on specific professions point to a similar conclusion. While the incomes of the creative class have generally kept pace with inflation, their ranks have shrunk—in some cases, drastically. From 1999 to 2015, the number of musicians and singers slipped 20%; photographers, 24%; news analysts, reporters and correspondents, 29%; dancers and choreographers, 42%. (Though these numbers don’t include the self-employed, freelancers tend to earn less than their counterparts with conventional jobs.)”

 

creativeclass_1numberofcreativeprofessionals

  1. “When the Rolling Stones started out they didn’t make any money out of records because record companies didn’t pay you. Nobody got paid. I always wonder if Frank Sinatra got paid. Your royalty was so low. If you sold a million records you got a million pennies. It was all very nice, but not what you imagined you were going to get.” “There was a small period from 1970 to 1997, where people did get paid, and they got paid very handsomely and everyone made money. But now that period has gone. So if you look at the history of recorded music from 1900 to now, there was a 25 year period where artists did very well, but the rest of the time they didn’t.”  Mick Jagger. That the economics of the music business are worse than they have been at some times in the past in not controversial. This unfortunate reality means that people need to be more creative in finding solutions. My blog post on Rza of Wu-Tang clan is about a musician who figured out how to change the rules so his share of the business is better. Just selling digital music is no longer enough.

global

 

  1. “People who cost too much: manager, lawyer, publicist, label, music publisher.” Roger McNamee. Every business has a “value chain.” Some portions of that value chain is not necessary and yet they may take a big a slice of the profits. What is going on in the value chain today is a battle over “wholesale transfer pricing” between the layers. Set out below is one depiction of some of the different types of people who are trying to get a slice of the profit from the music industry.

 

value chain

  1. “I’m not a businessman, I’m a business, man.” Jay-Z.  In the modern world of the music business much of the profit must come from complementary goods. That means concerts and merchandise and other services. The entertainer is a business. If they are not thinking  about different kinds of revenues related to the business they may not make enough money to stay in the business. One interesting thing Hip-Hop did was make it OK for a musician to sponsor goods again without being a sellout. That helps musicians work around the “public good” problem. This writer raises the idea of complementary goods as a partial solution:

“One interesting thing about this market is there are two major sets of players: Those who make their money solely from these music services and those who make the vast majority of their money elsewhere. Spotify and Pandora can’t afford to keep losing money in this business because it’s the only business they have. Amazon, Apple, Google and others, however, can afford to subsidize these offerings or run them at low margins because they feed the other parts of their businesses and generate additional revenue indirectly. Apple may be in the strongest position of all here, because it has a user base willing to pay for content and it can afford to run the music business at a relatively low margin, while Amazon’s customer base is highly driven by saving money, and Google’s true customer base is its advertisers, not its users. Much has been made of Spotify’s lead over Apple in on-demand streaming, but Apple offers the flavor of streaming the labels like and has already signed up half as many paid subs as Spotify.”

  1. “Grateful Dead Fans are like people who like licorice. Not everyone likes licorice, but the people who like licorice REALLY like licorice.” Jerry Garcia. I was never a Dead Head. But I know people who are. And I know people who love to hate Dead Heads. Frankly people who spend their lives talking about what “real music is” bores me. But I like a lot of things other people find boring so I should not complain. In any event, music is not an exception to the rule that there can be significant be benefits when a business differentiates. Being unique can create a moat. Professor Michael Porter writes: “It’s incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long.”  If you deliver the same product or service as your competitor you by definition don’t have a moat.  Competition will be based on price and price-based competition inevitably degrades to a point where profit disappears. Porter teaches: “if customers have all the power, and if rivalry is based on price… you won’t be very profitable.”  He adds: “Producing]the highest-quality products at the lowest cost or consolidating their industry is trying to improve on best practices. That’s not a strategy.”
  1. “I don’t waste my time thinking about how I could make more when I already got enough. I’m not a banker, I’m a musician.” “[Money] buys me freedom. It allows me to do what I want to do and not have to worry about anything at all.” Dave Grohl.  This famous musician seems to have a very firm grasp on the “circle of competence” idea. Grohl seems to recognize that risk comes from not knowing what you are doing. If you do not understand much about investing and finance, it is very wise to keep your approaches simple. Know your limitations. Be smart, by not being stupid.
  1. “To me, music was an escape from working in a furniture warehouse.” “I was a manual-labor worker, doing masonry and working at a furniture warehouse. I worked at a nursery breaking fucking rocks. There were not a lot of career opportunities for me. At one point, I thought, ‘I know how to play drums. I’ll learn to read music, become a session drummer and from that money, I’ll put myself back through school.” “I wanted to have a kickass job downtown, in Washington, D.C. But that wasn’t going to happen. In Washington, D.C., you’re either in the Army or the government. I was too skinny to be in the Army and too stupid to be in the government – or too smart.” Dave Grohl.  Many musicians are one hit wonders who therefore have short careers. They may need to live for a lifetime mostly based on the income from that one hit. Sports stars are similar. Yes, they can get another job after the music career ends but it may not pay nearly what they generated from a brief period of time creating music.  Since income can be very lumpy it pays to save. Grohl is far from a one  hit wonder, but he is financially careful nevertheless.
  1. “The reward of playing music should be playing music.” Dave Grohl. Enjoy what you do and you will not only be happier, but will be much more likely to be successful since you can adopt the attitude of a missionary not a mercenary. Missionaries survive through the tough times, which is usually what success in the music business requires. Many people work for many years in order to become an overnight sensation. It is important to note that what you love will likely change substantially over your lifetime. This is natural.  Tastes and desires evolve over the years, which is a good thing, since otherwise life can get boring.

Notes:

Duncan Watts: http://www.nytimes.com/2007/04/15/magazine/15wwlnidealab.t.html

Generation of Swine: https://books.google.com/books?id=hysRM1imbJ0C&lpg=PA43&pg=PA43#v=onepage&q&f=false

BBC: http://www.bbc.com/news/10581280

The Music Business:  https://www.budivoogt.com/understanding-music-industry-record-labels-ars-distribution-pluggers-pr/

Quartz:   http://qz.com/383109/the-music-industry-has-hit-its-rock-bottom/

Nesta: http://www.nesta.org.uk/blog/artistic-inequality-industry-or-human-nature

Recode: http://www.recode.net/2016/8/26/12645066/music-streaming-services-pandora-spotify-amazon-pandora

Rza: https://25iq.com/2016/01/02/a-dozen-things-i-have-learned-about-business-from-rza-the-founder-of-wu-tang-clan/

John Bersin:  http://www.forbes.com/sites/joshbersin/2014/02/19/the-myth-of-the-bell-curve-look-for-the-hyper-performers/#7ae8019d13fc

Neil Howe: http://www.forbes.com/sites/neilhowe/2016/08/31/the-new-rules-of-the-creative-economy/#695d7cc259f0

Pollstar:  http://www.pollstarpro.com/files/charts2015/2015YearEndBusinessAnalysis.pdf

New Math: http://nymag.com/arts/popmusic/features/grizzly-bear-2012-10/

A Dozen Things I’ve Learned from Michael Dell about Business (Pre-2002 edition)

If you have been reading this blog for a while you have probably figured out by now that my posts are a scheme on my part to write about topics that interest me in a way that is more interesting for readers. This blog post about Dell founder Michael Dell is no different. I try to work within a 4,000 word count on each blog post. For this post both for brevity and due to the nature of what I do for a living, I’m going to limit the discussion mostly to pre-2002 events.

As is usual, the Michael Dell quotes are in bold text:

1. “I believe that you have to understand the economics of a business before you have a strategy, and you have to understand your strategy before you have a structure. If you get these in the wrong order, you will probably fail.” Dell’s statement about economics is a reference to microeconomics and not macroeconomics. The distinction between these two types of economics was explained at the 2016 Berkshire shareholder meeting by Charlie Munger who said: “Microeconomics is what we do, macro is what we have to put up with.” Understanding microeconomics is essential if you want to be successful in business since as Munger went on to say business is essentially microeconomics. In his “Five Minute University” bit on Saturday Night Live, Father Guido Sarducci explained business simply: “You buy something and you sell it for more.” It is really quite simple. The math that determines whether you can “sell it for more” is called “unit economics.” How much can you profit from the sale of each unit of what your business produces?

Dell said in the quote above that once you have an understanding of the economics you need a strategy. What is a strategy? My most complete post on strategy is about Michael Porter, who has said: “Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different. The essence of strategy is choosing what not to do. Operational effectiveness is about things that you really shouldn’t have to make choices on; it’s about what’s good for everybody and about what every business should be doing.” After you have a strategy then you can create a structure says Dell. The original structure at Dell was three people assembling PCs working at a six foot table and two more people answering the phone with Dell performing the rest of the necessary functions at the company. The structure of Dell’s business has evolved many times, but always in relation to the underlying economics and the strategy of the business.

2. “When I was 19, I saw what I thought was a huge opportunity to change the way personal computers were made and sold. In high school I purchased and took apart one of the very first IBM PCs. I made two interesting discoveries: 1) none of the parts were made by IBM 2) the system that retailed for $3,000 actually cost IBM about $600. I immediately saw this as an opportunity. I started upgrading my own systems, using the same components as IBM, and selling them. The idea grew from there.” What a 19 year old Michael Dell saw in the PC business was “unit economics” that were quite favorable. Dell saw the opportunity to take $600 in components and transform that into a product that people would pay $3,000 for. Even better, none of the parts were made by IBM so there was no real barrier to entry and as a result IBM did not have wholesale transfer pricing power over his business. Dell was able to find favorable unit economics because Bill Gates also had a favorable strategy with respect to IBM. The most important business decision that took place in the earliest days of Microsoft was Gates’ decision to license Microsoft Basic to MITs (the manufacturer of very first PC known as the Altair) on a non-exclusive basis. This decision by Gates was enabled by the fact that multiple people and businesses can possess the same software at the same time at essentially no incremental cost (software is non-rival). Gates understood the difference between a license and an outright sale which was an essential enabler for both Microsoft and companies like Dell. Gates explained the history of one of the most important deals in business in this way: “The contract with IBM called for us to do all this work on the design of the machine and all this software. We didn’t get paid that much–the total was something like $186,000–but we knew there were going to be clones of the IBM PC. We structured that original contract to allow them. It was a key point in our negotiations.” Paul Allen elaborated: “We already had seen the clone phenomenon in the MITS Altair days. Other companies made machines that succeeded because they were similar to the Altair. For us it had been easy to modify our software so it worked on those machines too.” Not only was Dell able to surf on the phenomenon created by Gates and Allen, he was also able to create his own moat by making some key decisions as will be explained below.

3. “We started the company by building to the customer’s order. And interestingly enough, we didn’t do it because we saw some massive paradigm in the future. Basically, we just didn’t have any capital to mass-produce.” “While that was a great way to start the business, it turned out there was a lot more we could do with it, in terms of building relationships with suppliers, reducing inventories and receiving direct input from customers.”’ Most important, the direct model has allowed us to leverage our relationships with both suppliers and customers to such an extent that I believe it’s fair to think of our companies as being virtually integrated. That allows us to focus on where we add value and to build a much larger firm much more quickly. I don’t think we could have created a $12 billion business in 13 years if we had tried to be vertically integrated.” Dell started his business at a very auspicious time. Powerful forces were transforming the economy and that created massive opportunity for many business. In his 1999 essay Michael Mauboussin pointed out “source of value creation is shifting from physical capital to intellectual capital— from atoms to bits.” Better information technology systems (i.e., bits) allowed Dell to create a vertically integrated solutions with only a fraction of the capital that would have been needed in the traditional business world. Professor Gerald Davis describes this phenomenon:

“In 1950 it might have made economic sense to assemble cars in giant vertically integrated factories in Detroit and ship them from there to the rest of the world. Today, the parts of a business are like interlocking plastic bricks that can be snapped together temporarily and snapped apart when they are no longer needed. Information and communication technologies (ICTs) make starting an enterprise trivially easy, from creating a legal structure to hiring temporary employees to contracting out for production and distribution. Coordinating activities used to be the corporation’s strong suit. Now the corporation is increasingly out-maneuvered by alternative forms of enterprise that are more flexible and less costly. The barriers to entry are falling across a wide swathe of industries. In his famous 1937 article “The Nature of the Firm,” Nobel Prizewinning economist Ronald Coase explained, “The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price system. The most obvious cost of ‘organising’ production through the price mechanism is that of discovering what the relevant prices are.” But what if discovering the relevant prices becomes trivial? What if the inputs of a firm, including labor, can be priced and ordered as they are needed? What if, in place of long-term employees, firms were able to contract for workers if and when they were needed for specific tasks—the way that customers can use the Uber app to order a ride?”

4. “Inventory velocity is one of a handful of key performance measures we watch very closely. It focuses us on working with our suppliers to keep reducing inventory and increasing speed.” “We tell our suppliers exactly what our daily production requirements are. So it’s not, “Well, every two weeks deliver 5,000 to this warehouse, and we’ll put them on the shelf, and then we’ll take them off the shelf.” It’s, ‘Tomorrow morning we need 8,562, and deliver them to door number seven by 7 a.m.’” “Because we build to our customers’ order, typically, with just five or six days of lead time, suppliers don’t have to worry about sell-through. We only maintain a few days—in some cases a few hours—of raw materials on hand. We communicate inventory levels and replenishment needs regularly—with some vendors, hourly.” Dell did not have much capital when he started so he turned a weakness into a strength. Bill Gurley and Jane Hodges described the Dell strategy in a classic article from 1998:

“From a corporate perspective, the best measure of fitness is return on invested capital (ROIC). This measure matters most because over the long haul, capital flows toward investment opportunities with a high ROIC. Inefficient companies, on the other hand, are eventually starved of the cash they need to survive. To understand just how indispensable technology has become, you have to follow the basic math of return on invested capital. To get ROIC, you divide EBIT, or earnings before interest and taxes, by invested capital. Now let’s divide the numerator and the denominator by annual sales. This restates ROIC as operating margin multiplied by asset turnover. In other words, the two components that define a company’s fitness are the ability to charge a high spread between price and actual cost, and the ability to generate sales from a small base of invested capital…. companies that lack competitive information technology will be in serious trouble. They will resemble a 40-year-old trying to win Wimbledon with a small wooden racquet. Their business models may no longer be economically sustainable. Companies like Dell have reached an interesting new stage in the evolution of business–negative working capital. They collect money from customers before they have to acquire components or spend money. This phenomenon allows these companies to grow without raising capital, even if day-to-day profitability is zero.”

Gurley elaborated on Dell’s advantage in another article: “Dell’s incredible five days of inventory allows it to pass on component price declines faster than anyone else in the industry. But perhaps the unique aspect of Dell’s business advantage is its negative cash conversion cycle. Because it keeps only five days of inventories, manages receivables to 30 days, and pushes payables out to 59 days, the Dell model will generate cash–even if the company were to report no profit whatsoever.” Michael Mauboussin describes the results in his essay Atoms, Bits and Cash in November of 1999.

dellpic

5. “We’re free cash flow people.” Dell shares this attribute with many great operators like Costco’s Jim Sinegal. One of my post popular blog posts was on Jeff Bezos. One focus of that post is on his views on the right financial drivers of his business. Bezos is quite clear about what he seeks:

“Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that. So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.” “What matters always is dollar margins: the actual dollar amount. Companies are valued not on their percentage margins, but on how many dollars they actually make, and a multiple of that.” “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”

Justin Fox explains:

With free cash flow what counts is when the money actually changes hands. So if you have a business where your customers pay you quickly, you manage your inventory well, and you’re able to take your time in paying your suppliers, your free cash flow can be consistently positive even when your net income is not. Which is exactly the kind of business that Jeff Bezos and his colleagues have constructed at Amazon over the past decade. According to my instructor in such matters, Harvard Business School finance professor Mihir Desai, the key metric of a company’s cash-generating prowess is the cash conversion cycle, which is days of inventory plus days sales outstanding (how long it takes your customers to pay you, basically), minus how many days it takes you to pay your suppliers. Super-efficient retailers such as Walmart and Costco have been able to bring their CCC down to the single digits. That’s impressive. But at Amazon last year, the CCC was negative 30.6 days.

6. “The computer industry when [we] entered it had gross margins of 40 percent plus. On top of that, you had dealers with margins of 20 to 30 percent. So the end user was paying a pretty incredible premium over the cost of goods for the product.” “The basic idea was to eliminate the middleman.” “Every breakthrough business idea begins with solving a common problem. The bigger the problem, the bigger the opportunity.” Jeff Bezos famously said that the profit margins of his competitors are Amazon’s opportunity and Dell was an early believer in that approach to business. The longer I am involved the business the more I appreciate the value of being in a business with high gross margins. Life is just better when gross margins are high since you have headroom for sales and marketing as well as profit. By contrast, businesses with low gross margins tend to be soul crushing slogs where every penny spent is another way to go out business. Of course, high gross margins alone are not enough to make a business attractive. You also need a large market. And a moat. At one point I changed the focus of my career from the communications business to the software business and I must admit that a major motivation for the shift was the high gross margins available in software. There were other reason that attracted me like better scalability, but high gross margins are a wonderful thing to have in a business. As Warren Buffett has said: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

7. “If we can buy something that’s very similar to something we can create ourselves, we believe it might not be valuable for us to create it. On the other hand, if we’re thinking about creating something that nobody else has, that’s worth doing.” “Dell Computer came along and said, “Now wait a second. If I understand this correctly, the companies that do nothing but put chips on motherboards don’t actually earn tremendous profit doing it. If we want to earn higher returns, shouldn’t we be more selective and put our capital into activities where we can add value for our customers, not just into activities that need to get done?” I’m not saying those activities are unimportant. They need to get done very, very well. But they’re not sources of value that Dell is going to create. When the company started, I don’t think we knew how far the direct model could take us. It has provided a consistent underlying strategy for Dell despite a lot of change in our industry. Along the way, we have learned a lot, and the model has evolved.” Dell is talking about a point made by Andy Grove, who said once: “You have to understand what it is that you are better at than anybody else and mercilessly focus your efforts on it.” Professor Michael Porter argues “the essence of strategy is choosing a unique and valuable position rooted in systems of activities that are much more difficult to match.” Grove is saying that a business should find this comparative advantage and focus resources on it with passion. Businesses that try to do everything, often end up doing close to nothing.

8. “The consumer has better information, you have transparency of pricing. You can’t trick the consumer anymore. The businesses that had an advantage because they sold things in a geographic area where people had limited information, and they couldn’t travel to go buy something else. Those folks are in real trouble. The Net kind of destroys that business model.” “At the root of any economic system is the cost of transactions. You have something you want to sell, I want to buy it, and what that transaction ultimately costs is tied to the cost of communicating information. The Internet is the latest evolution of communication technology-tremendously powerful because it enhances the flow of information. So basically it’s like a big vacuum that sucks friction out of the economy.” Simply increasing product advertising is often not a solution to increasing sales due to higher levels of transparency enabled by Internet. When customers are as well informed as they are today the best way to acquire customers cost effectively is almost always with an organic customer acquisition strategy, meaning they are attracted to the service because it is a great service. Businesses that must sell their products with huge advertising budgets are losing their edge in the Internet era. Jeff Bezos of Amazon puts it this way: “In the old world, you devoted 30% of your time to building a great service and 70% of your time to shouting about it. In the new world, that inverts. Your brand is formed primarily, not by what your company says about itself, but what the company does.”

9. “Ideas are commodity. Execution of them is not.” “Coming up with the ideas is not the hard part for us. We got more ideas than we know what to do with. The hard part for us is prioritizing the best ones, picking them, and fielding teams to go after them all. We’ve gotta be careful. Because if we go after too many of them, well then we’ll fail to execute, because we won’t have the people, the resources. It’s sort of one foot in front of the other.” “People look at Dell and they see the customer-facing aspects of the direct-business model, the one-to-one relation-ships. What is not really understood is that behind these relationships lies the entire value chain: invention, development, design, manufacturing, logistics, service, delivery, sales. The value created for our customers is a function of integrating all those things.” “If you want to sustain excellence over a long time, you’d better come up with a system that works well. Anyone can sprint for a little while, but you can’t sprint for forty years.” In my blog post on John Doerr I quoted John Doerr as saying “We believe that ideas are easy, execution is everything.” A good idea or invention is necessary, but it is far from sufficient to achieve success in business. It takes an entrepreneur to take an idea or innovation and turn into genuinely scalable business. That means a “roll up your sleeves” and a “make the trains run on time” effort from a team of people. Bill Gates said once: “Being a visionary is trivial. Being a CEO is hard. All you have to do to be a visionary is to give the old ‘MIPS to the moon’ speech — everything will be everywhere, everything will be converged. Everybody knows that. Which is different from being the CEO of a company and seeing where the profits are.” The great CEOs I have seen over the years like John Stanton and Jim Barksdale are masters of execution.

10. “The inspiration initially was my own curiosity about technology and what it could do for people. But I had a sense of urgency about it in 1984. Like all windows of opportunity, they eventually close.” “You have to focus on the point of impact where you can really make a difference in something in a meaningful way. That’s going to evolve. Where you might have had an impact on something three years ago. If you did that same thing now, you wouldn’t have enough of an impact to matter.” Sometimes an opportunity comes along and it has a time stamp. You either grab that opportunity right then and bet big or it is gone. As an example, Bill Gates famously dropped out of Harvard to move to Albuquerque, joining Paul Allen in writing software for the Micro Instrumentation and Telemetry Systems Altair computer they first saw in a Popular Electronics magazine at a newsstand in Harvard Square. The price of the MITS computer in 1975 was $397. It was primitive and lacked easy-to-use software, but even then they could see the potential for this device since they experienced how valuable having access to a computer could be. Despite being their youth, especially in the context of how business was conducted at that time, Gates and Allen realized that if their business was not formed immediately they would miss the opportunity. Gates recalls: “When we saw [the Altair], panic set in. ‘Oh no! It’s happening without us! People are going to write real software for this chip!’” Dell saw his own opportunity and grabbed it. Charlie Munger’s advice is that a person needs a combination of patience and yet aggressiveness when the opportunity is right.

11. “Assets collect risks around them in one form or another. Inventory is one risk, and accounts receivable is another risk. In our case—with 70% of our sales going to large corporate customers—accounts receivable isn’t hard to manage because companies like Goldman Sachs and Microsoft and Oracle tend to be able to pay their bills. But in the computer industry, inventory can actually be a pretty massive risk because if the cost of materials goes down 50% a year and you have two or three months of inventory versus 11 days, you’ve got a big cost disadvantage. And you’re vulnerable to product transitions, when you can get stuck with obsolete inventory.” “Consider what to do with the investment that could be freed up by shedding inventory and other assets now on the balance sheet.” “One of the big changes that is brought about by information technology is that the cost of those connections and those linkages has gone down dramatically. So if you’ve got an operation that builds a component, the cost to communicate worth that operation in an information sense, if it is done electronically goes to zero. That means you can build a linkage between that components supplier and a manufacturer and make it very, very efficient. That enables you to scale more quickly, gives you more flexibility, you can manage supplier networks in a more dynamic fashion, and get things off your balance sheet that aren’t your specialty, and companies can really hone in on something that they’re really great at.” The many ways in which Dell grew by having great financial strategies and tactics is underappreciated. Dell had a succession of great CFOs over the years and it shows. Combine a great CFO and a great information technology infrastructure and that is rocket fuel for success. CFOs take a lot of criticism from engineers since they often put limits on spending. Which reminds me of a story. A CEO I knew took the company’s leadership team on a retreat to a resort that had a large swimming pool filled with hungry alligators. One night the CEO said to the executives: “A person should be measured by courage. Courage is what made me CEO. This is my challenge to each of you: if anyone has enough courage to dive into the pool, swim through those alligators, and make it to the other side, you will be my successor.” While everyone was laughing at the CEO’s crazy offer, they suddenly heard a loud splash. When they turned to look at the source of the splash they saw the CFO of the company in the pool, swimming for his life. Amazingly he swam so fast that he avoided the alligators and was able to make an exit using a ladder at the other side the pool with only a fraction of a second to spare. The shocked CEO approached the CFO and said, “You are amazing. I’ve never seen such courage in my life. You are clearly the right person to be my successor. Tell me what I can do for you.” The CFO, panting for breath, looked up and said, “Well, first of all, you can tell me who the hell pushed me into the pool!”

12. “Try never to be the smartest person in the room. And if you are, I suggest you invite smarter people… or find a different room.” Dell has always had a range of talented people working with him. One example is Thomas J. Meredith, who was at one time Dell’s chief financial officer. There are many other people who have contributed to the success of Dell over the years, many of which are mentioned in this article: entitled: Inside Dell Computer Corporation: Managing Working Capital http://www.strategy-business.com/article/9571?gko=d8c29  As Charlie Munger has said: “Acknowledging what you don’t know is the dawning of wisdom. I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.”

Notes:

Dell on Going Private: http://www.cnbc.com/2014/09/23/after-going-private-dell-isnt-looking-back.html

HBR Interview: https://hbr.org/1998/03/the-power-of-virtual-integration-an-interview-with-dell-computers-michael-dell

Justin Fox: https://hbr.org/2014/10/at-amazon-its-all-about-cash-flow/

Gurley and Hodges Fortune Article: http://archive.fortune.com/magazines/fortune/fortune_archive/1998/10/12/249302/index.htm

WSJ on the Dell Model: http://www.wsj.com/articles/SB944003985432882680

Technology Review Article on Dell: https://www.technologyreview.com/s/401105/direct-from-dell/

Mauboussin on CAP: http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/cap.pdf

Mauboussin on Measuring the Moat: http://csinvesting.org/wp-content/uploads/2013/07/Measuring_the_Moat_July2013.pdf

Mauboussin on Atoms, Bits and Cash: http://giddy.org/dbs/neweconomy.pdf

Professor Davis: http://vanishingcorporation.com/wp-content/uploads/sites/62/2016/02/Davis-Booksite-Excerpt.pdf

Mauboussin: Atoms, Bits and Cash: http://giddy.org/dbs/neweconomy.pdf

A Dozen Things I’ve Learned from Naval Ravikant about Investing, Business and Startups

“[Naval Ravikant] is an entrepreneur and angel investor, a co-author of Venture Hacks, and a co-maintainer of AngelList. Previously he]was a co-founder at Genoa Corp (acquired by Finisar), Epinions.com (IPO via Shopping.com), and Vast.com (white-label classifieds marketplace).”

1. “The cost of starting a company has collapsed.” “As the cost of running a startup experiment is coming down, more experiments are being run.” “Three years ago, companies could for the first time get all the way through a prototype of a service before they even raised seed money. Two years ago, they could make it through launch before raising money. Now, they can start to get traction with a user base by the time they come looking for seed money.” A capitalist economy is an evolutionary system. Innovation and best practices are discovered by the experimentation of entrepreneurs who try to establish the evolutionary fitness of their business. Products and services created as part of this experimentation which have greater fitness survive and other less fit products and services die. Entrepreneurs are essentially running experiments in this evolutionary system when they create or alter a business.  Entrepreneurs are engaged in “deductive tinkering” as they search for better products and services. Eric Ries describes the process in this way: “Learning how to build a sustainable business is the outcome of experiments [which follow] a three step process. Build, measure, learn.”

Why is experimentation so important in an economy? The answer is that experimentation is the best way to deal with one of nature’s solutions to dealing with risk, uncertainty and ignorance: a complex adaptive system. An economy is a complex system in that it is networked and therefore adaptive in ways that a simple formalism, such as used in physics, will fail to predict. Michael Mauboussin explains:

“A complex adaptive system has three characteristics. The first is that the system consists of a number of heterogeneous agents, and each of those agents makes decisions about how to behave. The most important dimension here is that those decisions will evolve over time. The second characteristic is that the agents interact with one another. That interaction leads to the third—something that scientists call emergence: In a very real way, the whole becomes greater than the sum of the parts. The key issue is that you can’t really understand the whole system by simply looking at its individual parts.”

In the case of complex adaptive systems like an economy or a business, the correct approach is to discover solutions via trial and error rather than try to predict. Nassim Taleb describes why the experimentation approach works well: “it is in complex systems, ones in which we have little visibility of the chains of cause-consequences, that tinkering, bricolage, or similar variations of trial and error have been shown to vastly outperform the teleological—it is nature’s modus operandi. But tinkering needs to be convex; it is imperative…. Critically [what is desired is to] have the option, not the obligation to keep the result, which allows us to retain the upper bound and be unaffected by adverse outcomes.” What Taleb is talking about is “convexity” which is something I have written a lot about recently. As an example of convex financial proposition, all a founder or venture capitalist can lose is 100% of what they invest in a startup and yet what they can potentially gain is potentially many multiples of that investment. People will inevitably say when the topic of complex adaptive systems comes up that nothing has emerged from research in this area that allows you to predict the future, which ignores the point that knowing what you can’t predict is one of the most valuable things you can know. Discovery which happens via experimentation via trial and error is a vastly superior way to deal with unpredictability than trying to predict what can’t be predicted.

It is important to note that Ravikant in the quotes above is talking about a specific type of business experiment. One way to look at the impact of business startups is to group them into two categories:

  1. Some startups are an attempt to create entirely new categories of businesses at global scale (e.g., Uber, Salesforce.com or Airbnb).
  1. Some startups are about incremental or local innovation, such as a new frozen yogurt shop or sushi restaurant.

The number of businesses trying to create value in category 1 through business experiments has substantially increased. Comparing a category 1 startup (e.g., a business that will try to achieve a level of success similar to Uber or Airbnb) to a category 2 startup (e.g., new frozen yogurt store on main street) is apples and oranges. As an aside, I believe anyone doing something like opening up a new restaurant or main street retailer deserves a medal for bravery. The competition they face on a daily basis is brutal. These category 2 entrepreneurs are vitally important parts of the what makes capitalism work..

It is also important to understand how much bigger category 2 is than category 1. The number of startups that obtain venture finance for the first time in a given year is relatively small. There are ~ 700-800 firms per quarter in the US which raise venture capital for the first time.  This data is from PitchBook:

FVC

In addition to firms that actually obtain professional venture capital funding there are also a much larger number of startups that are able to conduct experiments based on the personal capital of founders even before seed. I’m not aware of anyone who has compiled a reliable estimate of how many category 1 startup experiments fail to raise seed capital or bootstrap the business to success, but it is a significant number.  The same problem exists for anyone trying to estimate how many startups raise some “friends and family” money. This activity is just to diffuse and distributed to be accurately estimated. Nevertheless, the lower cost of conducting a startup experiments has increased the number of experiments and the level of innovation is higher as a result.

Comparing category 1 to category 2 shows how much bigger the latter category actually is in terms of absolute numbers:

“Firms are individual businesses, while establishments include multiple outlets for existing firms. The Brookings report specifically discussed entrepreneurship, which is why it used the numbers for firms. “The distinction between a new Chase Bank branch opening in your neighborhood versus a brand new community bank is critical — particularly when studying entrepreneurship”…. The  most recent data from Census, released in September 2014, that showed firm deaths in 2012 (424,864) still outnumbered births (410,001). That’s a difference of 14,863, and the figures showed that the gap had been narrowing each year since deaths first outnumbered births by 90,670 in 2009. But, it turns out, Census had released new numbers for 2013 in September of this year. And in doing so, it revised its figures for past years. The latest statistics now show that in 2012, firm births (411,252) were higher than firm deaths (375,192) by 36,060. And the same held true for 2013, when births outnumbered deaths by 5,666. We can expect that figure to be revised, too, when Census releases new figures in the future. …the latest numbers show that more firms are opening than closing.

Firm births

 

My trip to Omaha for the Berkshire shareholder meeting this year was interesting for many reasons but one fact that struck me was how many business, especially in West Omaha, are franchises.

A paper prepared for the Federal Reserve Bank of Cleveland, in August 2014 said there had been a shift away from brand-new businesses toward new outlets of existing businesses, a trend that many Americans may have seen in their own communities. “The Shifting Source of New Business Establishments and New Jobs,” Aug. 21, 2014: We find that while new firms have been forming at a slower pace over the past 33 years and creating fewer jobs, there has been a simultaneous rise in the number of new establishments opened by existing businesses (which we will call new outlets). … Markets that used to be served by independent entrepreneurs creating businesses are now increasingly being served by the expansion of existing businesses.

There are a lot more business in 2 category in absolute numbers but it is category 1 that generates the most fundamental innovation. Do I wish there was more business entry in category 2 and that they were more successful more often?  Definitely. Lots of jobs are created and taxes paid by businesses in category 2.

The additional point that must be considered is that innovation in category 1 can cause both more business failure and more new business starts in category 2. The outcome of this process varies since any given innovation can increase profit or not. Whether profit is generated by any given innovation is determined by the presence of a moat. Am I saying that some innovation at an aggregate level produces no profit or even less overall profit? Yes. Charlie Munger explains the phenomenon best:

“When technology moves as fast as it does in a civilization like ours, you get a phenomenon which I call competitive destruction. You know, you have the finest buggy whip factory and all of a sudden in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you’re dead—you’re destroyed. It happens again and again and again. There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.”

2. “Success rates are definitely coming down but that is because the cost of running a startup experiment is coming down…so more experiments are being run. In the old days, we would have one company spend $10 million to figure out if it has a market. Today, maybe that same company could do it under $1-2 million. The capital, as a whole, may make the same or better returns, but yeah, if the failures don’t cost a half of what they used to, you are actually saving money, it is a more efficient market.More experiments inevitably means more failures on an absolute basis. In addition, as the rate of business experimentation rises there will inevitably be an increase in the number of poseurs trying to create new businesses and that will increase failure rates. A lower overall success rate caused by an increase in the number of experiments is a positive tradeoff overall since society benefits from the increased level of innovation. This net benefit for society is created even though most experiments fail and some experiments are being conducted on the margin by poseurs who have little or no idea what they are doing. Success is found by any given business via negativa. For this reason, some failure is essential to the capitalist process since it is what fuels success. What the collapse of the cost of running business experiments has done is radically increased the pace of the discovery process that creates innovation. Because the creative destruction process is now operating as if it has taken steroids, the rate at which profit is turned into consumer surplus has never been greater, especially in the technology sector.

A real economy is messy and there is lots of failure. Failure is in fact an essential part of the process of creating innovation and a healthy economy. A fantasy economy in which fully informed and perfectly rational agents interact with perfect efficiency is believed to reflect reality only by a few people suffering from extreme forms of psychological denial. A child of ten knows humans are not perfectly informed and rational.  Failure is literally everywhere and is essential to making capitalism work given the economy is a nest of complex adaptive systems.

Despite the fact that experimentation is beneficial, it is interesting to think about whether there can be too much failure. Does the existence of too many startups in a given area like a city lower the overall benefit by diluting the talent available for startups of higher quality? I have argued previously that there is a Goldilocks “just right” level of startups that is unique for each city. That city A has a huge number of startups should not be the test of success but rather: what is the outcome of that activity? As many startups as are created in the Bay Area of California may not be optimal for a city like Seattle or New York. How big is the city? How much supporting infrastructure exists? What alternative employment opportunities exist? Does the city’s culture reward or punish failure? Is the culture in that city most supportive of missionaries or mercenaries? Does the city have a major research university?

At some level, the ability of an economy to grow is a brake on the overall level of success that can be created in a given time frame like a year or decade. To illustrate, Warren Buffett made a comment once that could be applied to unicorns waiting to go public as a group:

“Think about a [bunch of unicorns with a combined private valuation of] $500 billion. To justify paying this price, [they] would have to earn $50 billion every year until perpetuity, assuming a 10% discount rate. And if the [businesses don’t] begin this payout for a year, the figure rises to $55 billion annually, and if you wait three years, $66.5 billion. Think about how many businesses today earn $50 billion, or $40 billion, or $30 billion. It would require a rather extraordinary change in profitability to justify that [valuation].”

Regarding the amount that has been invested in breakthrough innovation, Mattermark calculates: “we found that 75% of the approximately $108 billion that investors deployed into these [software] companies is still locked up in private coffers.”

2003

I am conformable in predicting that I do not know who the outcome will be. Lots of unicorns may go public in the next year or two with an IPO, but perhaps in many cases only with a down round. That company A can’t go public at a valuation greater than $1 billion does not mean that it can’t go public at some price. Or maybe large numbers of unicorns will go public at flat or even higher levels. Of course some unicorns may be bought by large already profitable firms for defensive reasons, which allows financial exits by startups to exceed aggregate GDP growth by some amount. We will see what happens soon enough. That’s part of the uncertainty and fun of this process.

3. “The funding market is so bifurcated because outcomes are so bifurcated.” “Startup outcomes fall on a power law distribution. So startup financings look the same way. You’re un-fundable until you’re oversubscribed.” The financial returns from a tiny number of startups have always driven venture capital returns due the inherent convexity of technological innovation. This distribution of financial returns inevitably takes the form of a power law for the best venture capital firms. As just one example to illustrate, the ten biggest exits from 2014 look like this:

2014

2005 looks like this:

2015

Ravikant explains: “The nature of the markets have in many cases become more consumerized. People have caught on to how network effects work.” Network effects are increasingly driving financial success which phenomenon causes investors to put more investment into a smaller number of startups and firms that are deemed to have momentum. As a result, some firms can easily raise billions of dollars if investors see potential network effects, while other firms can’t raise even small amounts of capital.

I recently had a discussion on Twitter with Dave McClure (who I respect a lot) about the power laws in venture capital and my view is that a firm like 500 Startups that makes over 150-200 investments a year has a fundamentally different portfolio that a venture capital firm in the top decile of historical performance that makes < 10 investments a year. One recent survey survey reported that the average venture capital firm looks at 400 business a year and invests in only 5 businesses on average during that year. That data would means that these venture capitalists are investing in about 1% of the businesses they consider. McClure says that his financial return data does not look like a power law, but my view is that this does not mean other venture capital firms that embrace more convexity and make fewer investments do not have a return distribution that looks like a power law. All the data I have seen over the years indicates that top venture capital firms have a return distribution that reflect a power law. My thesis is that these views can be reconciled by looking at the composition of the two different portfolios. When financial exits reflect a power law and the head of the distribution is only a handful of companies, investing at a very high rate in any given year inevitably means you are in the tail for more investments.

PLVC

My thesis is that the 500 Startups portfolio is fundamentally different than the portfolio of a firm that Peter Thiel talks about below. This is from a blog post by Jerry Neumann linked to in the notes below:

“At a given alpha, the more investments you make, the better, because your mean return multiple increases with the number of investments, as does the likeliest highest multiple. Dave McClure makes this case:

‘Most VC funds are far too concentrated in a small number (<20–40) of companies. The industry would be better served by doubling or tripling the average # of investments in a portfolio, particularly for early-stage investors where startup attrition is even greater. If unicorns happen only 1–2% of the time, it logically follows that portfolio size should include a minimum of 50–100+ companies in order to have a reasonable shot at capturing these elusive and mythical creatures.’

Peter Thiel flatly contradicts this:

‘Given a big power law distribution, you want to be fairly concentrated. If you invest in 100 companies to try and cover your bases through volume, there’s probably sloppy thinking somewhere. There just aren’t that many businesses that you can have the requisite high degree of conviction about.’

McClure believes he can find hundreds of companies with high enough growth to maintain his requisite alpha. Thiel thinks this is not possible. Venture capitalists have always faced this tension: the average growth rate of all small businesses in the US is closer to 7.5% than 30%. The pool of companies that can grow fast enough is limited.”

PLLLL

My view is that both McClure’s and Thiel’s approaches to venture capital can be successful just as Warren Buffett and Ray Dalio can be successful with different investing approaches. The financial out-performance can come from different sources of mis-pricing for each of the two approaches. One interesting point: would venture capital  firms in the lower two quartiles improve performance by investing more like 500 Startups? The old joke is that all VC firms are in the top quartile, or at least that is what they say to their limited partners. Do you know any limited partners who have been pitched by a venture capital firms that says it is in the bottom quartile?

The discussion in this blog post to this point has not addressed more than a few questions: Why are financial outcomes in venture capital and business in general so bifurcated? What explains the presence of power law distributions? This topic is worthy of its own blog post, but in my view the simplest explanation is that there are many forms of feedback in a world that is a nest of adaptive complex systems and that feedback in all its forms creates the power law distributions. I have always loved this statement by Richard Feynman: “Imagine how much harder physics would be if electrons had feelings!” Duncan Watts describes how this manifests itself in this way: “individuals do not make decisions independently, but rather are influenced by behavior of others.” Humans are not like electrons- they have emotions, do things like herd and otherwise copy each other. That behavior can cause success and failure to feed back on itself, which produces outcomes that under the right conditions reflect a power law.

4.“The Internet is very efficiently arbitraged. Anything you can think of has been thought of and tried. The only way you’re going to find something is if you stick to it, at an irrational level and try a whole bunch of things.” The number of business experiments being conducted is increasing so quickly that the more obvious opportunity spaces for entrepreneurs are being exhausted with unprecedented efficiency and speed. There is no place to hide from the relentless pace of competition if the business person’s plan is to do something conventional. This places a premium on genuine product breakthroughs, often resulting from original research and development. In other words, convexity as a source of out performance is more important than ever.

5. “You get paid for being right first, and to be first, you can’t wait for consensus.” An investor can’t beat the market if they are the market. This is the point made so well by investors like Howard Marks. It is mathematically provable that being right will not lead to outperformance if the consensus forecast is also right. Howard Marks puts is this way: “To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Ravikant is saying that you also need to do it first. If you are not first, the bet will probably become consensus before you can capitalize on that bet.

6. “The market has to be huge because everyone makes mistakes. You never quite get it right the first time. Companies that don’t do giant pivots are always doing micro pivots. You need a large enough market that you can pivot in and you still have a customer base.” The convexity of a business investment (potentially massive upside and small potential downside) has never been so important. Having a huge addressable market increases the convexity of the potential financial outcome since it increases optionality. Small addressable markets provide entrepreneurs with fewer options and are not as likely to be convex.

7. “[A $1 billion seed fund would] destroy the entire market and put prices up 20% overnight.” “We don’t think we can allocate that kind of capital without distorting the market.” “Even the $400 million [we raised] will be spread out over six to eight years. Maybe the first year, we’ll deploy $20 or 30 million as we figure out the model, and then scale it out.” The market for venture capital is top down constrained by the potential for financial exits. This scalability problem in the venture capital business that Fred Wilson and others have written about means that in a country like the US only about 800 startups per quarter raised venture capital for the first time. If seed stage valuations get too high, the market can become distorted since it can become hard to raise funds in later rounds. Angel and seed considered together is only slightly higher as this chart indicates:

PBDEALS

 

As I noted above the economy is limited in its ability to generate exists at some level. Yes it can rise more over time with the right environment in place but number of financial exits doesn’t just suddenly jump 10x when overall GDP is increasing only at low single digit levels. One thing that may take the possible exit total higher is that some startup firms are purchased even though only consumers benefit from their existence and there is no net increase in GDP. This creates a weird asymmetry where startups can win without ever making a profit in some cases. The idea that sometimes only consumers benefit from innovation escapes many people. Some innovations have a moat and create profit and some innovations do not have a moat and create no profit.

pb1

 

pb2

 

8. “It’s just as hard to build a large company as it is a small company, so you might as well build a big company. It’s roughly the same effort.” This is yet another point related to convexity. The bigger the upside the greater the convexity.

9. “I use Warren Buffett’s criteria for assessing the Team: Intelligence, Integrity and Energy. You want someone who is really smart, very hard working and trustworthy. A lot of people forget the integrity part, because if you don’t have that, then you have a really hard working crook and they will find a way to cheat you.” “Intelligence and energy are easier to measure. Integrity is the most important factor.” An honest colleague or partners with integrity increases the convexity of an investment since trust gives you more options. Decisions can get made faster and with greater confidence. The work is fun. Life is better. People have actually does research to prove that people who life in high trust societies are happier.  A lot of research has also been done on how trust is a key enabler of an economy. The studies show that “high-trust societies achieve higher economic growth due to lower transaction costs. Since trust protects property and contractual rights, it is not necessary to divert resources from production to protection.” These same ideas about the value of trust are fractal and exist at a company and personal level.

10. “Companies only fail for two reasons: The founder gives up or they run out money.” “Don’t be proud. Get the cash wherever you can. Cash is everything.” “Raise twice as much and make it last four times as long. Pretend that you don’t have the money in the bank, run lean. Assuming your unit economics are at least breakeven, keep your headcount low, raise money and stay in it for the long haul. It takes a decade to build a great company. There’s no shortcuts.” The only unforgivable sin in business is to run out of cash. What does cash give a business? Options. What do options create? Convexity! By now you have probably figured out that convexity is everywhere if you know how to look. “There is a whole set of companies that are not financeable by the venture community; service businesses, markets that are heavily played out, if you are fighting a war that has already been won…you better have some really core differentiation and traction. [Other disqualifiers include] not enough technical people on the team…if you are completely out of market… pre-launch companies tend to not do well…teams that have no credibility. The companies that fail to raise funding are the ones who use too many words and too few actions. Your biography is a record of your past actions. Your execution on your current business is a record of your current actions. Talking about what you are going to do in the future is almost pointless. Talking about what you can become is almost pointless. People want evidence. There is a lot of talk out there.” Most startups will not be able to raise venture capital. That is not the end of the world for those businesses. There are many ways to finance a business that do not involve venture capital.

11. “When building a startup, microeconomics is fundamental, macroeconomics is entertainment.” “Getting real traction is hard. Raising millions of dollars is hard. Building a sustainable, long-term company is hard. Your pre-traction company has not  achieved product/market fit and so it has a hard time hiring.” “There isn’t a shortage of developers and designers. There’s a surplus of founders.” Understanding microeconomics is essential if you want to be successful in business. The distinction between these two types of economics was explained at the 2016 Berkshire shareholder meeting by Charlie Munger who said: “Microeconomics is what we do, macro is what we have to put up with.” Munger and Buffett elaborated on that point during this interchange:

BUFFETT: “Charlie and I read a lot and we’re interested in economic matters and political matters for that matter and so we’re familiar with almost all of that macroeconomic factors. That doesn’t mean we know where they’re going to lead. For example, where zero interest rates are going to lead.”

MUNGER: “We pay a lot of attention to microeconomic factors. If you’re talking about macro we don’t know anything more than anybody else.”

BUFFETT: “Yes, he summed it up. In terms of the businesses we buy – and when we buy stocks we look at it as buying businesses, so they’re very similar decisions – we try to know all or as many as we can know of the microeconomic factors. I like looking at the details of a business whether we buy it or not. I just find it interesting to study the species.”

MUNGER: “Well there hardly could be anything more important that the microeconomics, that is business. Business and microeconomics are sort of the same term.”

12. “Desire is a contract you make with yourself to be unhappy until you get what you want.” “Seems like too many people, public and private sector, are making a living slicing the pie rather than baking it.” “Figure out what you’re good at and start helping other people with it; give it away. Pay it forward. Karma sort of works because people are very consistent. On a long enough timescale, you will attract what you project.”  “If you are young, one of the best things you can do is build a brand around yourself.” Yeah, this last set of quotes is a grab bag of ideas but there is a lot to grab in what he says! This post is already at 4,000 words, so I will let his words speak for themselves.

 

Notes:

Anatomy of a Fundable Startup https://vimeo.com/25392719

Business Insider Interview:  http://www.businessinsider.com/interview-naval-ravikant-co-founder-angellist-and-co-maintainer-venture-hacks-2011-8

Nextweb: http://thenextweb.com/entrepreneur/2011/02/22/naval-ravikant-talks-in-depth-on-twitter-bubbles-new-york-and-start-fund-interview-part-2/#gref

Pando: https://pando.com/2015/05/08/naval-ravikant-to-vcs-you-can-lie-to-your-lps-but-dont-lie-to-yourselves/

Profile: http://dartmouthalumnimagazine.com/articles/avenging-angel

SJBJ: http://www.bizjournals.com/sanjose/blog/techflash/2015/06/angellist-chief-ravikant-its-a-bubble-but-not-just.html

CNBC: http://www.cnbc.com/2015/10/13/

CB Insights:   http://www.forbes.com/sites/niallmccarthy/2015/01/21/the-10-biggest-u-s-venture-capital-exits-of-2014-infographic/#660ae6322917

WSO http://www.wallstreetoasis.com/blog/the-current-state-of-startups-from-naval-ravikant

Power Laws in Venture http://reactionwheel.net/2015/06/power-laws-in-venture.html

Embracing Complexity  https://hbr.org/2011/09/embracing-complexity

Firm deaths and births:  http://www.factcheck.org/2015/11/a-gop-talking-point-turned-false/

Mattermark: https://mattermark.com/75-capital-invested-unicorns-still-locked-private-coffers/?utm_campaign=Mattermark%20Daily&utm_source=hs_email&utm_medium=email&utm_content=33087858&_hsenc=p2ANqtz-_oxddUidtX8i2-IRVA-CTZo5zp4YHD4joHvSJxGTvMmW_BIsyQ-oOi0eEEA3MTIfMS4Ur31j6mG9d1UDAHF9tJgcgkNw&_hsmi=33087858

A Dozen Ways Michael Bloomberg Thinks Like Charlie Munger

After graduating from Johns Hopkins University and Harvard Business School, Michael Bloomberg worked at Salomon Brothers. After he left Salomon Brothers, he started the financial news and information service known as Bloomberg. He was the 108th Mayor of New York City. After leaving City Hall, Michael Bloomberg returned to the company he founded.

As is usual for this blog, Bloomberg’s statements are in bold text.

1. “I think if you look at people, whether in business or government, who haven’t had any moral compass, who’ve just changed to say whatever they thought the popular thing was, in the end they’re losers.” Charlie Munger: The culture now is that anything that can be sold for a profit will be. ‘Can you sell it?’ is the moral test, and that’s not an adequate test.” Munger is unrestrained on this point: “I think we have lost our way when people like the [board of] governors and the CEO of the NYSE fail to realize they have a duty to the rest of us to act as exemplars. You do not want your first-grade school teacher to be fornicating on the floor or drinking alcohol in the closet and, similarly, you do not want your stock exchange to be setting the wrong moral example.”

2. “In 1981, at the age of 39, I was fired from the only full-time job I’d ever had—a job I loved. But I never let myself look back, and the very next day I took a big risk and began my own company based on an unproven idea that nearly everyone thought would fail; making financial information available to people, right on their desktops.” Many people are thrust into a situation with significant optionality by losing a job. When you are already in a position where you have little to lose taking a risk with a potentially big upside can be easier to do. Munger has said that he “developed courage when I learned I could deal with hardship. You need to get your feet wet and get some failure under your belt.”

3. “Persistence really does pay off.” Charlie Munger agrees: “Be persistent: Slug it out one day at a time.” On the subject of persistence, venture capitalist Mark Suster has said: “Tenacity is probably the most important attribute in an entrepreneur. It’s the person who never gives up—who never accepts ‘no’ for an answer….what I look for in an entrepreneur when I want to invest? I look for a lot of things, actually: Persistence (above all else), resiliency, leadership, humility, attention-to-detail, street smarts, transparency and both obsession with their companies and a burning desire to win.”

4. “The most powerful word in the English language is ‘Why.’ There is nothing so powerful as an open, inquiring mind. Whatever field you choose for starting a business—be a lifelong student. The world is full of people who have stopped learning and who think they’ve got it all figured out. Their favorite word is ‘No.’ They will give you a million reasons why something can’t be done or shouldn’t be done. Don’t listen to them, don’t be deterred by them, and don’t become one of them. Not if you want to fulfill your potential—and not if you want to change the world for the better.” People who get ahead most in life are invariably lifelong learners. They read, study and are inquisitive. Charlie Munger puts it this way: “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time — none, zero.”

5. “I’m a very lucky guy.” “You can’t control how lucky you are, you can’t control how smart you are, but you can control how hard you work, so that’s the first thing.” Charlie Munger has similarly said: “Well, some of our success we predicted and some of it was fortuitous. Like most human beings, we took a bow.” Michael Mauboussin points out: “Skill is ‘the ability to use one’s knowledge effectively and readily in execution or performance.’ You can think of skill as a process, or a series of actions to achieve a specific goal. Luck is the events or circumstances that operate for or against an individual.” “Luck, in this sense, is above and beyond skill. Consider luck as a distribution that has an average of zero. By this definition, luck tends to be transitory. Note that many common phrases, like ‘you make your own luck,’ ‘luck is what happens when preparation meets opportunity,’ and ‘the harder I work, the luckier I get,’ do not fit with our definition. In each of these cases, luck is conflated with skill. Think of luck as something in addition to skill.”

6. “Being a plumber is a great job because you have pricing power.” [The plumber father of one of my employees has] got six plumbers working for him, he’s a scratch golfer, he goes around playing golf courses I only dream about. He’s built a business, he’s had a chance to do that. He never went to college.” A business that can raise prices and demand for the product does not drop significantly has pricing power. Some firms have so much pricing power that they can raise prices and demand goes up. If a business must hold a prayer meeting to raise prices it does not have a moat. A business may have factors that may create a moat in the future, but the best test for a moat is in the end mathematical. Munger believes:

“There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. … Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells … came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies… At Berkshire Hathaway, Warren and I raised the prices of See’s Candy a little faster than others might have. And, of course, we invested in Coca-Cola—which had some untapped pricing power. And it also had brilliant management. So a Goizueta and Keough could do much more than raise prices. It was perfect.”

7. “I always give the most difficult and complicated assignment I have to the most overworked person in the company. There’s a reason they don’t have time — work is a marketplace, and it’s telling you this person is good.” What a market does is drench people who want something or make or sell something with feedback says Charlie Munger. Without feedback it is not only hard to respond and adapt to changing conditions, but to figure out who has talent and who is willing to work hard.

8. “None of you are going to be Mark Zuckerbergs. It’s just not going to happen.” As Charlie Munger says about investing: “It’s not supposed to be easy.” If it was easy anyone could do it.” The magnitude of financial success of someone like Zuckerberg or Gates happens extremely rarely. This must be so simply due to the top down math involved. There is only so much profit and revenue to be captured in any given economy given the normal workings of competitive capitalism. Financial success follows a power law distribution.

top1001

9. “If you say, ‘Look, my father never existed, my mum had cancer, I’m working five shifts at McDonald’s,’ that’s the person I’m going to hire.” Charlie Munger: “Life will have terrible blows in it, horrible blows, unfair blows. And some people recover and others don’t. And there I think the attitude of Epictetus is the best. He said that every missed chance in life was an opportunity to behave well, every missed chance in life was an opportunity to learn something, and that your duty was not to be submerged in self-pity, but to utilize the terrible blow in constructive fashion. That is a very good idea. You may remember the epitaph which Epictetus left for himself: “Here lies Epictetus, a slave maimed in body, the ultimate in poverty, and the favored of the gods.”

10. “Capitalism works.” Munger has similarly said, after giving the hat tip to Allen Metzger: “I regard it as very unfair, but capitalism without failure is like religion without hell.” Innovation and progress requires failure. Lots of failure. As Warren Buffett said in his 2015 shareholder letter: “Nothing rivals the market system in producing what people want – nor, even more so, in delivering what people don’t yet know they want.” Capitalism isn’t a perfect system, but it is the best one available by far. Markets sometimes fail, but that can be dealt with wise regulation.

11. “I don’t believe that government is good at picking technology, particularly technology that is changing. By the time you get it done and go through democracy, it’s so outdated.” What a politically driven process lacks is the ability to get real feedback in a timely way about the nature of a given decision. Many political systems are created with a set of “checks and balance” which work against efficiency. Munger: “The constant curse of scale is that it leads to big, dumb bureaucracy—which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn’t mean we don’t need governments—because we do. But it’s a terrible problem to get big bureaucracies to behave.”

12. “Life is too short to spend your time avoiding failure.” Munger puts it this way: “The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don’t. It is just that simple.”

Notes:

Mike Bloomberg: https://www.mikebloomberg.com/about/

The Venture Capital Power Law – Analyzing the Largest 100 U.S. VC-Backed Tech Exits https://www.cbinsights.com/blog/venture-capital-power-law-exits/ 

WSJ on Bloomberg: http://topics.wsj.com/person/B/Michael-Bloomberg/4365

 

 

A Dozen Things I’ve Learned from Bill Draper about Investing and Business

“William H. Draper, III  started his career in venture capital with Draper Gaither & Anderson, the first venture capital firm west of the Mississippi, working there with his father from its creation in 1958 until he left to cofound Draper & Johnson Investment Co. in 1962.  Three years later, Draper & Johnson merged with Sutter Hill Ventures to great success. From 1981-1986, Draper served as President and Chairman of the Export-Import Bank of the US, continuing on to become the Administrator and CEO of the United Nations Development Program, serving until 1995. He is also a co-founder of Draper Richards Kaplan Foundation, a venture philanthropy group focused on early-stage, high impact organizations. He is the author of The Startup Game: Inside the Partnership Between Venture Capitalists and Entrepreneurs.”

 

  1. “Venture was far more profitable 40 years ago than it is today.” “When I was there, the returns at Sutter Hill were 42 percent.” “[There was] much less competition.” “In the early days of VC, the returns were so attractive that they got Wall Street’s attention. But then perhaps it was too much attention.” “It’s not as cozy and not as nice and not as profitable as it used to be.” “It’s much better for the entrepreneur now. The entrepreneur has a chance to go to lots and lots of places. If he doesn’t like Draper, he has a chance to go to Valentine or some other firm.” “This has been good for the overall economy, because it has meant more entrepreneurs could get started. If there were many fewer venture capitalists, perhaps a company like Facebook or Skype wouldn’t have been created in the first place, or been able to get funding.” Competition between venture capitalists has made the world a better place for founders and consumers. The nature of capitalism means that value in any business is constantly moving from producer surplus to consumer surplus driven by increasing competition. Venture capital is not an exception to this phenomenon. The bigger the venture capital business gets and the more money is under management, the harder it us to generate significant out-performance over a benchmark financial return. Timing matters and being early in the venture business was great luck for some people like Draper. Michael Moritz of Sequoia once said at a Fortune magazine conference: “a chimpanzee could have been a successful Silicon Valley venture capitalist in 1986.” Both today and in the past, financial success in the venture capital business overall is top down constrained by the number of successful exits as Fred Wilson pointed on is a classic post on the business. Fred wrote: “$100bn in [venture capital exits in a given year] produces roughly $50bn in proceeds for venture firms per year. After fees and carry, that $50bn is around $40bn. Which is only 1.6x on the investor’s capital if $25bn per year is going into venture funds. If you assume the investors capital is tied up for an average of 5 years (venture funds call capital over a five year period and distribute it back over a five year period, on average), then the annual return is around 10%.” If venture capital industry exits are at the level in the chart below the overall financial returns will necessarily be constrained by the level of financial exits in industry.  As I have written before, venture capital industry returns are far from spread evenly like peanut butter between all of the venture capital firms. The better venture capital firms capture the lion’s share of the financial returns in the industry. The venture capital business is certainly not like Lake Wobegon where all firms are above average. If the top down industry constraint is ~$100B a year on average, only so many startups (unicorns or otherwise) can achieve an exit in a given year.

pitch

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  1. “We had many fewer failures in [the early years of venture capital] In our day we had really very few losses.  At Sutter Hill, we had a lot of doubles and triples and not many strikeouts.” “We didn’t have the billion dollar hit, although there were one or two of those.” I believe that the change in the success rate that Draper describes is a natural outcome of increasing competition in the venture capital business. Since risk capital was relatively scarce in the early years the financial returns in venture capital could be excellent even without finding what Draper calls “the billion dollar hit.” As venture capitalist skill levels and capital under management rose over the years, venture capitalists found themselves needing to find new undiscovered sources of value as the obvious bargains disappeared. This process is similar to what happened to value investing when after a period of years after the end of the Great Depression the obvious “cigar butt” bargains disappeared. Venture capital like value investing was forced to evolve. As an analogy, in value investing the change took the form of people like Phil Fisher and Charlie Munger starting to consider quality in assessing whether a bargain was present. In the venture capital industry, Doriot’s massively successful investment in DEC provided a huge clue about where to find undiscovered and undervalued opportunity. What venture capital industry learned from the financial outcome of DEC was that convex payoffs (nonlinear payoff properties that create massive potential upside and small potential downside) which benefit from uncertainty and disorder could generate very attractive financial returns. A portfolio approach was required in venture capital since only a very small number of outsize winners determine the financial outcome of a given fund. Warren Buffett describes the strategy adopted:

“If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments.  Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.  Most venture capitalists employ this strategy.  Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.”

By investing in businesses that can generate convex payoffs venture capitalists have been able to generate the returns we see in venture capital today. Because payoffs from convex propositions are determined by complex systems financial returns in modern venture capital reflect a power law distribution. Draper is saying that this was not the case in in the early years.  My thesis is that investments like ARD made in DEC fundamentally changed the venture capital business. Draper has his own theory on why there were less failures in the early years, but I just don’t see it as being sufficient to drive the magnitude of the change. He said:  “I think the reason [for fewer failures] is we’d share deals with other venture firms, so that you check your judgment, you get your broader contacts, you get more information, and you have a more cooperative spirit.  It was a lot less competitive than it is today.  Today, there’s these huge companies, and they want to get it all because they’re very hungry.  ‘Feed me, feed me, feed me!;  So that’s something that has changed.  But “The size and the lack of cooperation among venture capitalists [has changed]. It’s hard for them to get a 10 million dollar deal and divide it up and say to Sutter Hill or Sequoia, why don’t you take half of it? We used to do that all the time.” Of course, Draper was actually there and I was not. So you might want to believe his thesis is right instead of mine.

There is one more important point to make that is relevant to what Draper said above abut a lower failure rate in the early years.  In the United States there are only about 3,600 startups a year (~800 per quarter) that obtain first time venture capital from a professional investor. That leaves about 280,000 other startups every quarter that need to either raise some form of capital or bootstrap themselves financially. There is room for many other business financing models including what some call “Indie VC” and other approaches that involve cash flow financing like merchant based finance from a factor. Cash flow based financing is available and has a cost that varies with the approach. But it is  not “disruptive” to venture capital.

 

  1. “For every hundred entrepreneurs, we say yes to four or five. Saying no is the worst part of the job.” Finding a venture capital investment that has the requisite amount of convexity (huge potential upside and small potential downside) is a bit like looking for a needle in a haystack. A venture capital firm may look at thousands of different investments before deciding to invest in as few as two to five businesses a year. Marc Andreessen points out: “the basic math component is that there are about 4,000 startups a year that are founded in the technology industry which would like to raise venture capital and we can invest in about 20. We see about 3,000 inbound referred opportunities per year we narrow that down to a couple hundred that are taken particularly seriously. There are about 200 of these startups a year that are fundable by top VCs.” No one likes to deliver bad news to a founder, but that is part of the job. The venture capitalist does not do the founder any favors if they string them along when they know the answer is no. A founder should realize that hearing the word “no” from venture capitalists is almost always part of the process.

 

  1. “Venture capital was not a word known out here.  It was known to me and my father and a lot of people in New York because of J.H. Whitney and the Rockefellers were known to do some venture capital.  They backed Minute Maid, and Eastern Airlines, but those were both family operations.  I knew it more because of General Doriot who, while he was teaching, was also starting up and running American Research and Development.  AR&D was a venture capital company that made the big mistake of having a public issue, and being a public company, having to answer to stock holders.  [It was a mistake] because in this business it’s just not earnings that you can predict.  It’s very blocky, and you don’t really know what the value is of your assets either.  So that combination made it very awkward to be a public company.” I have already written a blog post on Georges Doriot and his struggles in creating AR&D. Limited partners who understand that venture investments are not liquid and take a long period of time to pay off are a great luxury for a venture capitalist. The very best limited partners have been involved in venture capital for decades and aren’t doing things like rushing to find a secondary market to unload their holding in the events the market turns negative. Venture capital has always been a cyclical business. Limited partners who can ride out the down cycle end up with superior financial returns as a reward for their patience. A venture capitalist who has experienced and thoughtful limited partners will be better at his or her job since they will not be distracted as much by the antics of nervous limited partners.

 

  1. “I consider all characteristics of success, but it’s the CEO, the entrepreneur, that’s the most important among all the factors.” Great people, attractive markets and significant innovation are all required for a business to become a success. Different founders and venture capitalists put different emphasis on these three elements of success at different stages of the evolution of a business. Robin Richards, who co-founded Draper Richards Kaplan with Draper once said: “You’ll find that other investors tend to ask whether the market makes sense and that people are interchangeable. Bill will take on business risk. He doesn’t want to take on people risk. He wants to make sure he can really work with that person or people. That’s what makes Draper unique. He’s always been about the people.” In this way Draper is more like Pitch Johnson and Eugene Kleiner when it comes to people. He would rather take on market risk or technical risk that people risk. Of course, risk and problems related to people can appear to be low at first and then appear as the business evolves. One interesting thing about the rise of software-based business models is that it is not nearly as common today for technical risk to be the primary concern of investors and founders. As a result, most of the risk that a founder must retire is now market risk, if you get the people issues right.

 

  1. “The entrepreneurial mind is an inquisitive mind.” I rarely meet a founder who is not a curious person and successful founders who are not curious are even rarer. I have also found that inquisitive people inevitably like to read. Not only do they like to read, but they read broadly. The best founders typically ask great questions and love to learn. Successful founders also tend to have strong opinions that are weakly held (they believe in what they believe because they have done the research to feel that way but can quickly adapt if new evidence becomes available). Eric Ries talks about why an inquisitive mind is so valuable in a founder: “As an entrepreneur everything you do – every action you take in product development, in marketing, every conversation you have, everything you do – is an experiment. If you can conceptualize your work not as building features, not as launching campaigns, but as running experiments, you can get radically more done with less effort.”

 

  1. “Venture capital is not all about money, it’s really mostly about building a company with the entrepreneurs who do the heavy lifting.” Implicit in this statement by Draper is that the best venture capitalists help with “light lifting.” Different venture capitalists and firms have different models for how much support they provide to portfolio companies. Venture capitalist support can range from:  (1) extensive support from so-called platform approaches which offer end-to-end support (public relations, marketing, finance, recruiting, sales, distribution etc.) to (2) lighter touch support where the VCs get involved in only a few issues like recruiting or scaling growth in addition of their board duties. For example, Chamath Palihapitiya has a system where: “our growth team can help them implement the right data infrastructure, implement the machine learning, implement the right sort of customer acquisition metrics and reporting.” Other venture capital firms have full time recruiters on staff. A first time technical founder will have different needs than an experienced founder, so that there is a range of available venture capital options for founders to choose from is a good thing. Marc Suster writes that a founder should: “Beware of VC Seagulls, who shit on you and then fly away (or worse yet leave you with Red Herrings).  The best VCs act as a sounding board for management.”

 

  1. “When an entrepreneur has a first board meeting, we called that the ‘Oh shit meeting.’ That’s when the VC finds out the bad news he didn’t know when he made the investment. How the VC reacts to that defines the relationship – it either becomes more brittle or closer.” Honesty is important in any relationship. Not only is honesty the right policy morally but it is vastly more efficient. Charlie  Munger puts it this way: “You’ll make more money in the end with good ethics than bad. Even though there are some people who do very well, like Marc Rich – who plainly has never had any decent ethics, or seldom anyway. But in the end, Warren Buffett has done better than Marc Rich – in money – not just in reputation.” Being ethical and honest is good business and in addition a necessary part of being a good person. Of course, sometimes problems are discovered that have nothing to do with a lack of honesty. A venture capitalist in a board meeting or otherwise may discover things that the founder(s) do not realize are a significant problem. Helping to resolve those problems is part of being a valuable board member. Since relationships like this tend to be both long in duration and intense, strong relationships can be formed just as they do during other life changing events like college or the military. The venture capitalist-founder relationship is sometimes said to be like a marriage, except it is harder to get a divorce.

 

  1. “Very often [Founders] overestimate the size of the market that their product or service will reach and underestimate what it takes in the way of a timeline (and) a team. Sometimes they make the mistake of thinking they can do everything themselves.” “We often tell (entrepreneurs) they have underestimated the timeline – toward becoming profitable or becoming an exit candidate, for example. They’d say, ‘No, we’ve doubled the time we think it will take.’ Then we double that timeline, and very often that’s not enough.” If founders were not optimistic and confident they would not be founders. For example, founders would not be able to withstand the many critics who will inevitably say that are crazy. As a result of this optimism and confidence Draper is saying that founders may get ahead of themselves a bit and the board’s job in part is to make their estimates more realistic without choking off their ambition. This is often tricky. I have written about board members like the late Coach Bill Campbell who understand how to strike the right balance. The best venture capitals are patient. As a result of skills developed via pattern recognition the best venture capitalists can provide excellent guidance of timing and staging.

 

  1. “A great firm name isn’t worth much if the actual partner on your board isn’t very good.”A great venture capital firm is valuable to a founder since several partners are sometimes available to lend a hand if needed. What Draper is saying is that the quality of a board partner within that firm has great importance for a given founder. This is particularly true for the lead venture capital firm or firm involved in a startup since it is often that partner or partners who are critical in helping the firm raise the next funding round. Not having a lead investor just to minimize dilution can be penny wise and pound foolish. A lead investor who will signal to others that the business is a sound investment is invaluable.

 

  1. 11. “[Some founders have] the misconception that things will take care of themselves and that the competition will stay the way it is. Nothing stays the same. So the inflexibility becomes a problem.” The old saying that the only constant is change is true. If a business ever earns a profit or even seems likely to earn a profit competition will inevitably arrive. The ability to successfully adapt to change is part of what makes a great founder and, in and of itself adds, to the convexity of the investment. In other words a great team of people give a business valuable added optionality that is often essential to success given the need to adapt. Draper is saying that he has at times had to encourage founders to be more flexible to respond to competition. Striking the right balance on this set of issues is key, since the founder’s motivation and persistent nature are important to maintain. Sometimes what looks like dogged founder persistence sends a business right off a high cliff and at other times it is the key to success. Knowing the difference between suicidal moves talented differentiation is part of what separates a great venture capitalist from a bad venture capitalist.

 

  1. “Venture Capital started because of Stanford University.” “Without Stanford there would be no Silicon Valley. There’s just lots of structural support in Silicon Valley.” Generating strong economic growth in ant region of the world requires a major research university as an anchor.  There is no substitute in a modern economy for this engine of growth. If you look at which areas of the world are economically successful, you inevitably see at least one major research university. If a given city or region does not have a major research university it should try to affiliate with a city that does. Silicon Valley not only has Stanford but Berkley and UC San Francisco. Of course, there are range of other support services that a region must have to generate successful technology businesses. When all of the necessary factors come together any given city may find itself having significant success but it is not likely that it will be another Silicon Valley, but rather it will find its own version of success. I have written about this topic previously:   http://www.geekwire.com/2016/12-things-seattle-can-teach-others-jobs-economic-development-building-better-city/

 

Notes:

The Startup Game: Inside the Partnership between Venture Capitalists and Entrepreneurs  https://www.amazon.com/Startup-Game-Partnership-Capitalists-Entrepreneurs/dp/023010486X?ie=UTF8&tag=bisafetynet-20

Interview http://www.aaa.si.edu/collections/interviews/oral-history-interview-william-f-draper-12973

HBS Interview http://www.hbs.edu/entrepreneurs/pdf/bill.draper.pdf

WSJ Interview: http://blogs.wsj.com/venturecapital/2011/01/12/bill-draper-takes-stock-of-a-venture-capital-industry-he-helped-create/

Interview transcript: http://bancroft.berkeley.edu/ROHO/projects/vc/transcripts.html

Fortune: http://fortune.com/2011/01/21/qa-with-bill-draper-on-venture-capital-startups-and-skype/

Video: http://www.valleyzen.com/2008/07/08/bill-draper-draper-richards-exclusive-video/

A Dozen Things I’ve Learned from Andy Grove about Business and Strategy

 

“Andrew S. Grove was born in Budapest, Hungary in 1936. He graduated from the City College of New York in 1960 with a Bachelor of Chemical Engineering degree and received his Ph.D. from the University of California, Berkeley in 1963. Upon graduation, he joined the Research and Development Laboratory of Fairchild Semiconductor and became Assistant Director of Research and Development in 1967. In July 1968, Grove participated in the founding of Intel Corporation. In 1979 he was named President, and in 1987 Chief Executive Officer.”

 

  1. “Success breeds complacency. Complacency breeds failure. Only the paranoid survive.” “I believe in the value of paranoia. Business success contains the seeds of its own destruction. The more successful you are, the more people want a chunk of your business and then another chunk and then another until there is nothing left.” Grove believed that some degree of fear is healthy for any business, especially if the businesses has been successful. Two business school professors who have studied Grove point out: “A touch of paranoia—a suspicion that the world is changing against you — is what Grove prescribes.” The Economist magazine describes Grove’s application of what one might call a “paranoia principle” as follows: “[Grove] argues that every company will face a confluence of internal and external forces, often unanticipated, that will conspire to make an existing business strategy unviable. In Intel’s case, such a ‘strategic inflection point’ arose because its memory-chip business came under heavy assault from new Japanese rivals willing to undercut any price Intel offered.” Strategic inflections points are created when a business faces an order-of-magnitude change in their environment. The two professors argue: “Grove offers a ‘six forces’ framework for identifying strategic inflection points. He starts with Michael E. Porter’s five-forces model: customers, suppliers, competitors, potential competitors, and providers of substitutes. He then adds complementarity to the strategy map.” Grove wanted to be sure that if there was the potential for convex outcomes Intel would be well positioned to benefit and if there was the potential for a concave outcomes Intel would be well positioned to avoid harm. Grove identified a range of factors he worried about in in his book Only the Paranoid Survive: “I worry about products getting screwed up, and I worry about products getting introduced prematurely. I worry about factories not performing well, and I worry about having too many factories. I worry about hiring the right people, and I worry about morale slacking off. And, of course, I worry about competitors.” Grove recognized that competitors will inevitably be attracted to any source of profit and that increasing competition will drive returns down toward the opportunity cost of capital. What was once profit (producer surplus) is inevitably eventually transformed by competition into consumer surplus. This shift of value from producer to consumer is now new. What is new since the arrival of Moore’s law and the proliferation of digital networks is how fast this transformation of profit into consumer surplus happens. It is increasingly hard for any business to maintain pricing power in the face of (1) technological progress and (2) intense and rising levels of global competition. Companies are finding it hard to meet their investment hurdle rates give this phenomenon and so cash often piles up or is distributed rather than being reinvested.  People involved in a real business know that innovation often reduces rather than increases profit. Consumers always benefit from innovation but GDP may actually shrink as a result of the innovation. Charlie Munger put it this way once: “There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.” The point here is simple: some innovations create a moat due to the presence of factors like network effects and some innovations destroy moats. More consumer benefit is wonderful for society, but so is some healthy level of producer surplus since this is what powers a healthy growing economy.

 

  1. “Technological change is going to reach out and sooner or later change something fundamental in your business world.” Once upon a time there was a distinction between technology businesses and other businesses. Today every business is a technology business. As a result if this shift, a technological change can quickly create a strategic inflection point for any business. For example, John Deere is no longer a supplier of farm equipment but rather a provider of integrated productivity solutions for agriculture. Ford is no longer just a supplier of automobiles. Companies like John Deere and Ford increasingly find themselves in competition with other businesses that they never thought of before as competitors and also as partners with firms that they never though they would partner with. The wrong response to a strategic inflection point proved to be the undoing of companies like Kodak, Nortel and Motorola. The right response can create powerful new sources of profit for a business.

 

  1. “If existing management want to keep their jobs when the basics of the business are undergoing profound change, they must adopt an outsider’s intellectual objectivity. They must do what they need to do to get through the strategic inflection point unfettered by any emotional attachment to the past.” “I do have a lot of strong feelings. When it gets to one of those, I guess I state them pretty forcefully. I don’t thrash out and yell (but) maybe some people think it sounds like yelling.” Grove believed in “constructive confrontation.” To put it bluntly, an encounter with Grove was often intense. He wanted issues brought out into the open, fully discussed and decisions made in a very timely way. In an interview in Chicago Tribune in 1996 he said: “We encourage our people to deal with problems without flinching. At its best, the method means that people deal with each other very bluntly.” I am quite familiar with business discussions reflecting this level of intensity. I have been in numerous meetings in which the people involved argued their positions so vociferously that spittle was flying back and forth across a conference table. I see less of this behavior than I did in the 1980s and 1990s but it still happens sometimes. What most people do not understand about meetings like this is that after the issues have been “fully and candidly discussed” the people involved are capable of making a decisions at the conclusion of the meeting and the doing something like getting hamburgers together as if the intense confrontation never happened. It also surprises some people to learn that when someone important in the technology industry says nothing when you are making a presentation it can mean that they think you are an idiot. In technology, it is often the case that the more someone confronts what you are saying the more they may believe what you are saying is important or interesting. If you are not familiar with this bluntly confrontational environment, it can be disconcerting. As just one example, Larry Ellison and Steve Jobs were at a dinner once in which Grove said he would not have hired either of them since they were “flakes.” Ellison recalls: “Both Steve and I admired and respected Andy. We enjoyed all of our precious time with him, including the memorable and characteristic abuse.” I am not saying that all technology managers are confrontational. I worked for many years for Craig McCaw and he was the polar opposite of Grove when it came to blunt confrontations. Craig McCaw is the politest and most private person I have ever known. He just has a different style than someone like Grove. What McCaw and Grove do share is mastery at confronting their own ideas. This self-confrontational approach can be an effective way to deal with: (1) confirmation bias and (2) avoiding situations where the CEO does not hear the truth since his or her staff is unwilling to deliver bad news or push back on the CEO’s opinions. I agree with Charlie Munger that an effective manager or investor knows the other side of the argument better than the people who he or she disagrees with. Since most mistakes are psychological or emotional, attachment of these factors to the past is banished by the most effective managers since that baggage is what an accountant would refer to as “sunk.”

 

  1. “Intel [is] a data driven company and the phrase is, ‘Don’t argue with the emotions, argue with the data.’” “Measurement against a standard makes you think through WHY the results were what they were. Former Intel executive Pat Gelsinger said once: “If you went into a meeting [with Grove], you’d better have your data; you’d better have your opinion; and if you can’t defend your opinion, you have no right to be there.” Grove joked at his last shareholder meeting about his drive to obtain the very best data: “I didn’t enjoy myself 100 percent of the time. According to my statistical analysis, it was about 80 percent.” The amount of data that is available today is unprecedented and modern machine leaning tools that can analyze that data are evolving at a breakneck pace. Grove was an admirer of other businesses that have learned to use data well, For example, he said once:  “Amazon is the preeminent pioneer in building a new way of doing commerce: personalized, database-driven commerce, where the big value is not in the purchase fulfillment, but in knowing as much about a customer base of ten or twenty million people as a corner store used to know about a customer base of a few hundred. In today’s mass-merchandising world, that’s largely gone; Amazon is trying to use computer technology to re-establish it.” Moats are increasingly resulting from the ability of a business to apply analytics to the data that their business generates. There is a feedback loop at work: the more successful a business is the more data they generate, the more successful that the business is [repeat].

 

  1. “Most companies don’t die because they are wrong; they die because they don’t commit themselves. They fritter away their momentum and their valuable resources while attempting to make a decision. The greatest danger is standing still.” That decisions get made in a timely way as part of Grove’s “constructive confrontation” is critical. Eugene Kleiner once said: “The more difficult the decision, the less it matters what you choose.” What Grove and Kleiner mean is that sometimes you are better off making a decision and living with it than agonizing over the decision for a long period and as a result experiencing a significant delay. What can kill a shark is when it stops moving in the water and a business today can be killed in much the same way. Business momentum matters since feedback effects are so powerful. If competitors harness new network effects or other phenomena while a business is unable or unwilling to make a decision, the result can be very harmful or even deadly.

 

  1. “I think it is very important for you to do two things: act on your temporary conviction as if it was a real conviction; and when you realize that you are wrong, correct course very quickly.” “Investment decisions and personal decisions don’t wait for the picture to be clarified.” “It’s not that you shouldn’t plan but you should not regard your plans to be anything more than a baseline model of what might happen.” This point made by Grove is consistent with the “strong opinions, loosely held” idea that I have written about before. We all face a world filled with risk, uncertainty and ignorance. The best approach is to have strong opinions that reflect the best research and data possible, but that can be changed as new and better data becomes available. The world is more connected every day by digital networks and this creates phenomena that feed back on themselves which creates unpredictable turbulence. Outcomes are much more likely to be determined by genuinely complex processes than in the past. In other words, the world will evolve in ways that many businesses will not anticipate since the business environment is increasingly nonlinear. If a business is not preparing for this level of change to increase in both scope and magnitude, it may get caught in a turbulent riptide of change and find its business battered or even destroyed.

 

  1. “You need to try to do the impossible, to anticipate the unexpected. And when the unexpected happens, you should double the efforts to make order from the disorder it creates in your life. The motto I’m advocating is — Let chaos reign, then rein chaos. Does that mean that you shouldn’t plan? Not at all. You need to plan the way a fire department plans. It cannot anticipate fires, so it has to shape a flexible organization that is capable of responding to unpredictable events.” “There are two options: adapt or die.”  Dwight Eisenhower is famous for saying: “In preparing for battle I have always found that plans are useless, but planning is indispensable.” Survival in the long term is determined by adaptability, rather than size or strength. Using the preparation process to get ready to change that will produce surprising and sometimes shocking outcomes is wise. Expecting to be able to successfully respond to change by pulling out a prepared plan is a triumph of hope over experience.  Denial is not just the name of a river in Egypt, it is the leading cause of the death of businesses.

 

  1. “The new environment dictates two rules: first, everything happens faster; second, anything that can be done will be done, if not by you, then by someone else, somewhere.” A digital connected world is an accelerated world. Everything moves faster now due the advance of technology and networks. Everyone has better information and that information is dispersed faster than ever and so any advantage a business has that is merely better operational effectiveness can be copied far quicker. The speed at which a new competing business can be created has never been faster. The ability of businesses to compete from half way around the world has never been easier. Accelerating these phenomena even more is that fact that capital for genuinely good idea is not scarce. As Professor Michael Porter points out, operational effectiveness is very important, but it is not a strategy. Strategy is about what a business does differently than its competitors to create a sustainable competitive advantage. What does your business do differently that will create what Warren Buffett calls a moat against competitors? If you have a moat it is more valuable than ever since they are scarce, but also more at risk that ever before too.

 

  1. “Long distances used to be a moat that both insulated and isolated people from workers on the other side of the world. But every day, technology narrows that moat inch by inch. Every person in the world is on the verge of becoming both a coworker and a competitor to every one of us.” “You have no choice but to operate in a world shaped by globalization and the information revolution.” Moats have never been under more threat. Globalization and innovation have never been stronger as driver of change. The impact of globalization is taking a front seat in the world of policy and business today. Some people are now arguing that globalization has gone too far. The reality may be, however, that it may not be possible to put that genie fully back in the bottle. Since globalization is to some degree here to stay no matter how the political environment  changes, many aspects of society will need to be rethought as a result. The idea that the world can change as quickly as it is now, but that societal institutions can stay the same is unrealistic. This is equally true for a business.

 

  1. “You have to understand what it is that you are better at than anybody else and mercilessly focus your efforts on it.” Comparative advantage is the ability of an individual or group to engage in a particular economic activity (such as manufacturing a product or writing software) more efficiently than another activity. Professor Michael Porter argues “the essence of strategy is choosing a unique and valuable position rooted in systems of activities that are much more difficult to match.” Grove is saying that a business should find this comparative advantage and FOCUS resources on it with passion. Business that try to do everything end up doing close to nothing. Grove said once on this point: “A question that often comes up at times of strategic transformation is, should you pursue a highly focused approach, betting everything on one strategic goal, or should you hedge? Mark Twain hit it on the head when he said, Put all of your eggs in one basket and WATCH THAT BASKET.” As Mark Cuban has said you can’t diversify your way into knowing what you are doing.

 

  1. “The Internet doesn’t change everything. It doesn’t change supply and demand.”  Charlie Munger made a similar point when he said the Internetincreases efficiency, but lots of things increase efficiency without increasing profits. It is way more likely to make American businesses less profitable than more profitable. This is perfectly obvious, but very little understood.” Without a moat against competition that places some limits on the supply of what you sell, profit will not arrive. Warren Buffett said at the last Berkshire shareholder meeting that microeconomics defines what a business is and the Internet does not change the fundamentals of microeconomics. Grove has said on this point of microeconomics: “There is a time-dimension involved in the adjustment of one system to another. And by the time a supply-and-demand imbalance develops in one area of the economy, you can be very much out of phase with what is happening elsewhere. In physics, the equivalent would be unstable oscillations; in medicine, it would be heart palpitations. Economists don’t bother with that. They take one picture in a steady state, and another picture in a steady state, and somehow they think nature will smooth everything out. Often it does, but just as often it does not.”

 

  1. “Technology will always win. You can delay technology by legal interference, but technology will flow around legal barriers.” “Technology happens, it’s not good, it’s not bad. Is steel good or bad?” Technology will always find a way to route around obstacles. It is a question of when barriers to the adoption of technology will be circumvented not whether it will happen. Technology itself is morally agnostic. Society must learn to use it in ways that are beneficial. William Gibson agrees with Grove on this point: “I think that technologies are morally neutral until we apply them. It’s only when we use them for good or for evil that they become good or evil.”

 

Notes:

Only the Paranoid Survive  https://www.amazon.co.uk/Only-Paranoid-Survive-Andrew-Grove/dp/1861975139

High Output Management  https://www.amazon.com/High-Output-Management-Andrew-Grove/dp/0679762884

Grove Essay:  http://www.intel.com/pressroom/archive/speeches/ag080998.htm

Interview with his biographer: http://hbswk.hbs.edu/item/the-history-and-influence-of-andy-grove

Inside Intel:  https://hbr.org/1996/11/inside-intel

Quartz: http://qz.com/645327/silicon-valleys-confrontational-management-style-started-with-andy-grove/

Economist: http://www.economist.com/node/14299624

 

A Dozen Things I Learned Being Involved in one of the Most Ambitious Startups Ever Conceived (Teledesic)

 

 

I’ve decided to write this blog post about one of the more interesting business stories that has never really been told accurately. The story started for me when I was hired in 1994 to join a company that would become known as Teledesic as the fourth employee. This startup’s mission was to provide communications to the world regardless of location. Early in the process of designing the system it become evident that the nature of the available spectrum when combined with the greatest market need meant that it should be focused on providing broadband communication and not just telephony services. I had been involved in the mobile industry since the 1980s and knew the power of communications to make people’s lives better. So the mission of the startup was very appealing to me.

Craig McCaw and Bill Gates were the founding shareholders of the company, but were not involved in the day-to-day business of the company. My friend Russ Daggatt was the second employee to join the company and Elaine Ferguson was our co-conspirator. We started Teledesic in a couple of furniture cubes in the offices of what was then McCaw Cellular (it was sold to AT&T two years later). We had nothing really at the start but a modest amount of cash, our chutzpah and the reputations of our founding shareholders. Teledesic’s plan was audacious: build and operate more active satellites than any other previous satellite constellation – originally the plan was for 840 active satellites (reduced to 288 satellites in 1997). The original estimate of the system cost before any service could be provided was $9 billion. The idea for Teledesic was a spinoff of a military system called “brilliant pebbles.” Ed Tuck originated the idea for Teledesic, but it had been shepherded by the first employee, an engineer named Dave Patterson. There were many other very talented people involved in Teledesic that I could name but this is a short blog post not a book (which I may write some day). Some people involved Teledesic may disagree with aspects of this post since experiences like this are a bit like the famous Japanese movie Rashomon by Akira Kurosawa. If you have seen that movie you know it is about different people recalling contradictory versions of the same intense collective experience.

I turned down an offer of a very attractive job Microsoft the day I joined Teledesic in 1994. That day I told Bill Gates that I felt a need to do an ambitious startup sometime in my life and that I was passionate about making Teledesic happen. He said he understood why I turned down the Microsoft job, but he probably thought I was nuts. Not too nuts though, since he was an founding investor in what I was about to do. I have written before on this blog that the ideal venture investment is “half nuts” so it has the requisite convexity to create the potential for a 50-1,000x financial return. I also have written many times on this blog that missionaries act differently and are willing to do more things to make a startup successful than mercenaries. From 1994 until 1999 I threw my life into making Teledesic’s business a reality. You probably have heard the story about the chicken being involved in breakfast because she laid an egg but that the pig was committed to breakfast since he supplied the bacon. Investors are like the chicken, but startup up employees are like the pig. I flew over 500,000 air miles a year for five straight years to help retire Teledesic’s financial, regulatory and technical risk. I worked constantly. Other Teledesic employees where working just as hard accomplishing  impressive things on the technical, business and regulatory aspects of the business. An amazing multi-disciplinary team was assembled in Kirkland, which is a suburb of Seattle. If I name one more of these people I would feel compelled to name them all.

Based on the incredibly positive reputation of our founding shareholders we were able to meet with just about anyone on earth in developing Teledesic. People I met with around the world inevitably would look at me dumbfounded as I told them about a constellation of hundreds of satellite circling the Earth providing broadband service. The New York Times once called the number of satellites involved in the Teledesic system design “mind boggling.” But since Craig McCaw and Bill Gates were involved most of these people not only listened but decided to get involved. The arc of the startup’s existence coincided with the Internet bubble so we had a tailwind that enabled us to plan to make fantastic things happen.  The business climate for new ventures like Teledesic started to get even more positive when the Mosiac browser was released on November of 1993. After Netscape went public in August of 1995 the business and investing climate in the technology world started to get euphoric. Raising the $9 billion needed to build the system seemed more possible every day.

Like any startup that is worthy of venture capital Teledesic had all the elements of “the struggle” for the team trying to make it happen. Sleepless nights. Worries. Things going right and wrong. When I talk to a founder, my experiences at Teledesic color my world view and advice. Ben Horowitz describes the struggle involved in a startup beautifully:

“Your product has issues that will be very hard to fix. The market isn’t quite where it was supposed to be. Your employees are losing confidence and some of them have quit. Some of the ones that quit were quite smart and have the remaining ones wondering if staying makes sense. You are running low on cash and your venture capitalist tells you that it will be difficult to raise money given the impending European catastrophe. You lose a competitive battle. You lose a loyal customer. You lose a great employee. The walls start closing in. Where did you go wrong? Why didn’t your company perform as envisioned? Are you good enough to do this? As your dreams turn into nightmares, you find yourself in The Struggle.”

There were many things to worry about at Teledesic. We faced technology risk, financial risk and market risk. The experience was exhilarating and frightening at the same time. Teledesic did not have the support of everyone in the orbit of the founders in the early days. At one point when the startup had only had seven employees an executive named Wayne Perry who had worked with Craig McCaw for many years in the mobile and cable businesses said: “The problem with Teledesic is Russ and Tren – they just won’t let it fail.” Wayne was not a fan Teledesic in its early days, but many other people were fans. People in general love space-based businesses. Who doesn’t marvel as they look up at the sky on a clear dark night?

Through sheer force of will, the reputation of the founding shareholders  and a lot of work, the small but growing team at Teledesic took the business forward clearing regulatory and other hurdles that others thought would certainly kill us. The peak of achieving the impossible was in 1995 when we achieved a regulatory win thought unwinnable at a World Radio Conference in Geneva. What we did in about six weeks in Geneva was simply unheard of in regulatory circles. Wired magazine wrote at the time:  “It was a giant party, complete with favors,’ said an executive at wireless phone company Qualcomm, who, like seven other attendees of the 1995 conference interviewed by Wired News, talked about the conference on the condition of anonymity. These seven echoed the accounting of events at the WRC ’95. Other delegates remembered it differently – as a lobbying effort never before seen at a World Radio Conference. ‘What was unprecedented, I believe, was the scale and systematic aspect of this lobbying effort,’ noted a French delegate.” We were pirates with an entertainment budget and modern communications tools like the Internet and mobile phones. I loved being a pirate. It is about as much fun as you can have with your clothes still on.

By the fall of 1998 other opportunities were proliferating in the business world and I was asked by Craig McCaw to become more involved in other aspects of his communications and software businesses. By 1999 I was only involved in Teledesic as an advisor. By then the Internet bubble was in near full swing with lots of interesting and challenging things to do in private equity and venture capital.  A talented team was in place at Teledesic to take it forward so I felt relatively good about moving on. I did have one major nagging concern. Giant companies like Boeing and Motorola were getting involved as Teledesic contractors and that meant space and other systems for Teledesic which kept growing both in terms of size and cost. The involvement of the huge contractors also made being involved in Teledesic less fun.  The days of being a pirate in a startup known as Teledesic seemed to be ending, and were being replaced by traditional processes and thinking typical in giant defense and space companies. One brilliant thing that founders like Elon Musk and Jeff Bezos are doing today with their involvement in space-based businesses is not creating  dependencies on these traditional high cost contractors. To do so would create wholesale transfer pricing problems that would kill their efforts to reduce cost, as I will explain below.

At the time I ceased being a Teledesic employee in 1999 people still believed in the dream especially since by then valuations were skyrocketing daily as people suspended disbelief about many aspects of financing a business. Anything seemed possible during those years, even the idea of raising the needed $9 billion for building the proposed Teledesic satellite system. But about two years later the business climate changed for the worse rather abruptly. People who did not live through the internet bubble simply don’t understand how quickly things changed. One day you could raise billions of dollars to build something like a massive fiber based national or global telecommunications network and the next you could literally not raise 3 cents. Just reading about this shift in the ability of a business to raise new funds is not sufficient to convey how swift the change from internet bubble to internet bust really was. If you went through the internet bubble and its collapse you were forever changed. Your muscle memory is just different than other people who did not have the same experience.

In the end the financial, technical and business risks associated with Teledesic could not be retired. A non-geostationary system must serve everywhere to serve anywhere so the constellation was an all or nothing effort. The ground antennas given technology at the time would have been too expensive and complex given the frequency band (Ka) and the satellite system costs were just not low enough since a cubesat approach was not being adopted. Non mechanical inexpensive antennas at that frequency are still a year away from being available even today. When Teledesic was trying to purchase launch services in 2001 entrepreneurs like Elon Musk and Jeff Bezos were not driving down launch costs and cubesat-style satellite systems were not being built yet since Moore’s law was not quite far enough along. The traditional manufacturers like Boeing and Motorola did not want to enable cubesat-style systems, so cost estimates skyrocketed and satellite size ballooned. The traditional manufacturers wanted to re-use the massive satellites they had already developed so the number of satellites in the proposed system needed to be reduced. These traditional manufacturers did not want cheap satellites since their military and government customers would want them too. They liked the idea of PhDs assembling massive satellites in clean rooms out of custom parts since it created a barrier to entry. I wrote about this price elasticity problem of a legacy manufacturer in my blog post on Elon Musk. Sometimes people will say that the Teledesic system shrunk in size since Boeing or Motorola had a better design. That is bullshit. The proposed Teledesic system shrunk because the legacy satellite manufacturers had huge satellites they already manufactured and they did not want to make small satellites since that would require new engineering and a new business model. Most importantly, the legacy satellite manufacturers did not believe they would sell many more satellites if they were cheaper.

Elon Musk and others like Greg Wyler’s OneWeb satellite system have revived the original Teledesic idea of constellations of hundreds and even thousands of satellites. I am optimistic these systems will get built and become operational. What is different now and what might make it happen? First, Moore’s law has had a couple of turns since then and more is possible at substantially less expensive price points. But more importantly a new group of people have been making very small “cubesats” in ways that some more traditional people involved in space would consider “a toy” These cubesats are tiny and simple by traditional standards and manufactured from off the shelf parts in many cases in a relatively normal manufacturing facility at far lower cost. These cubesats are getting better and better and can be up-sized to bigger dimensions (for example 250 kilograms) to make them powerful enough to do communications and not just imaging. The biggest question I have actually is not whether these system can be built and financed but rather: what is the total addressable market (TAM) for these communications systems given the cost of the services and the the necessary antennas? Is there enough demand and the prices that will be charged to make the business case work financially? The radio frequency bands (Ka and Ku) and distances involved most likely mean the communications systems will be used for communications backhaul. Low frequency LTE on the satellite does make not make much sense (channel bandwidth and structure are completely different). Greg Wyler’s OneWeb is planned for Ku/Ka frequencies and therefore is likely to be a system that will be used as backhaul for mobile cell towers and by big customers like the military. I am skeptical that the pictures of small villages using the system to create direct links to the satellites depict a realistic market scenario, but they do help with regulatory approvals. More communications backhaul in hard to reach areas is good for the world, but these systems are not likely to be an affordable scalable broadband communications end-user solution for ordinary users. Having said that, providing emergency broadband communications capability in areas with problems like epidemics and natural disasters is important. Will backhaul be nearly all fiber and terrestrial microwave or will some satellite satisfy some of the demand? What role can drones play in all of this?  Is there enough other demand from other markets like ships, airplanes, NGOs  and the military to make the systems financially successful? I have opinions on that market demand and approaches like drones, but writing about that topic is not right for a short blog post like this. There is already a risk that you may be getting a little bored with parts of this story. In any event, we will find out about the size of market demand for space-based communications systems soon enough.

During its life, the Teledesic team raised over a billion dollars at a valuation that was as  high as a $3 billion. Teledesic was a triple Unicorn in its time. But when it was determined by the Teledesic board of directors that the business could not retire enough of the financial, technical and business risks to proceed, a decision was made to liquidate and hundreds of millions of dollars were distributed back to shareholders. This distribution of cash back to shareholders was and still is relatively unprecedented since most companies in a similar situation just pivot again and again to new businesses ideas until the cash is all gone. The math of corporate finance meant that early Teledesic investors received a significant multiple as a financial return on their investments even though it was a liquidation. One early investor to this day marvels that he received many times his original investment in a company that never provided service. Shareholders who invested at a higher valuation like $3 billion were not so fortunate.

Winding up any startup is never a happy time, but Teledesic was a valiant effort undertaken by a very talented team that paved the way for other similar systems to be built someday. It was also great fun and a wonderful life experience to be involved in the startup, especially in the early days. As Jeff Bezos wrote recently, “failure and invention are inseparable twins.” Negative results provide knowledge to everyone about what will not be a success. That makes it easier to determine what can be successful. Failures enable us to not only make new mistakes but to create genuine and lasting innovation. If you are not occasionally failing in what you do, you are unlikely to achieve great things.

A Dozen Things I Learned at Teledesic:

  1. It is more fun to be a pirate than join the navy. Pirates know how to break the eggs needed to make the necessary omelet. We broke a lot of eggs.
  2. Most people are not cut out for the startup life. It is not for everyone.
  3. Certain periods in your life are right for being involved in an audacious startup, and other periods are not.
  4. Flying 500,000 air miles a year for five years takes a big physical toll on your body. I still pay a physical price for that time in my life.
  5. Almost everything in life that is technically interesting and important involves trade-offs.  This is especially true in space.
  6. The more great people you hire, the easier it is to hire great people. Positive feedback can be powerful.
  7. The better the quality of your existing shareholders, the easier it is to attract new high quality shareholders.
  8. Having smart, talented and accomplished lead investors is invaluable in raising funds.
  9. Space is very big. The distance to a non-geostationary orbit around the Earth is not so big, but launching any mass into that orbit is still relatively expensive.
  10. There are no electrical outlets or power cords in space. This creates hard problems for systems that need power. 
  11. Since power density of an electromagnetic wave is proportional to the inverse of the square of the distance from a point source, space-based communications isn’t easy.
  12. Billionaires love space and rockets.  A rocket launch is like a big very controlled explosion.  Explosions that are very controlled and hurt no one can be great fun. Billionaires like to have fun.

 

Notes:

Wired on Teledesic:   http://archive.wired.com/science/discoveries/news/1997/10/7655

New York Times on Teledesic: http://www.nytimes.com/2000/06/04/business/can-craig-mccaw-keep-his-vision-of-teledesic-from-crashing.html?pagewanted=all

The Teledesic System: http://3csysco.com/Pubs/Teledesic%20Satellite%20System%20Overview.pdf

The Struggle by Ben Horowitz  http://www.bhorowitz.com/the_struggle